Author(s):	Roel Beetsma, Konstantinos Mavromatis
Publication Date:	December 2012
Keyword(s):	blue and red bonds, debt bias, debt guarantee, eurobonds, political distortions, social welfare, structural reform
JEL(s):	E60, E62, H60, H63
Programme Areas:	International Macroeconomics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=9244

We analyse different forms of international debt mutualisation in a simple framework with a political distortion and (partial) default under adverse economic circumstances. One form is a debt repayment guarantee, which can be "unlimited" or "limited", i.e. only be invoked when the guarantee threshold is not exceeded. We also explore the "blue-red" bonds proposal, under which blue debt is guaranteed by the other countries in a union, while red debt is not guaranteed. Only a suitably chosen limited guarantee induces the government to reduce debt and raises social welfare. Making the guarantee also conditional on sufficient structural reform may stimulate reform effort. However, now a trade-off exists between extracting more reform and inducing the government to limit debt issuance.