Interest-Rate Spread and Public-Debt Dynamics in a Two-Country Monetary-Union Portfolio Model

Tracking, monitoring and steering the evolution of public debt over time will be a major policy challenge for almost all governments in the advanced countries in the years to come, in particular for those belonging to the European Monetary Union. In this paper I study public debt dynamics in a two-country monetary union where a representative, risk-averse wealth-owner optimizes his/her portfolio of sovereign bonds issued in the common currency. I obtain two main results with respect to the standard country-by-country approach. First, the interest-rate spread between the two countries is endogenized as the higher-debt country pays a risk premium which is proportional to the level of its own debt with respect to the debt of the other. Second, its debt dynamic path becomes nonlinear and dependent on the evolution of the other country's debt. The most important policy implication is that "dynamic interdependence" is not fully considered in the implementation of EMU fiscal rules, but it may may jeopardize their goal of convergence and stability of debt stocks.