Giancarlo Corsetti and Luca Dedola have a really good VoxEU piece on how cooperation between the central bank and the fiscal authority can avoid the “bad equilibrium” problem for sovereign debt. The paper on which the Vox article is based is available here; Paul Krugman discusses it here.
Although the initial focus is on a country with control over its own “printing press”, they also examine how it could work in a monetary union. I won’t try to summarize the subtle analysis, but the key is how the difference between the interest rates on sovereign debt and central bank reserves can be used to lower the cost of funding below the level that triggers the bad equilibrium. In contrast to claims that potential central bank intervention has to be unlimited, a central finding is that limited central bank intervention may be sufficient to avoid a bad equilibrium.
In regard to how it might work in a monetary union, a sting in the tail comes in the last sentence of their closing paragraph.
The analysis here bears key lessons for the current debate on sovereign default in a monetary union:
· Countries in a monetary union could indeed be more vulnerable to debt crises, to the extent that the common central bank cannot count on the joint support of national fiscal authorities;
· The common central bank, however, still has the power to engineer successful interventions.
In doing so, it will have to weigh the benefits and costs of providing a backstop to countries exposed to debt crises, possibly drawing on seignorage accruing to all countries in the union.
“[D]rawing on the seignorage accruing to all countries in the union” raises the familiar political-economy of-transfer-risk problem that has complicated the task of stabilising stressed euro zone sovereign debt markets.