An interesting debate has been taking place following Ken Rogoff’s recent FT piece on the risks of UK sovereign default. [Update: Rogoff responds to Krugman here.] Simon Wren-Lewis has argued that the risk is overblown given that the UK has can conduct an independent monetary policy (see here). In extremis, the Bank of England could simply print money to cover debts as they come due. Also, QE could be used to lower the cost of funding to the government. (See also the argument of Giancarlo Corsetti and Luca Dedola how co-ordination between the central bank and the treasury could ensure the creditworthiness of the government even without the need for the central bank to act as an unlimited lender of last resort.)
A more provocative response to Rogoff comes from Paul Krugman. Using a stripped down New Keynesian open economy model (pdf) he argues that the government’s loss of creditworthiness could actually be expansionary in a liquidity trap. I hasten to add that this analysis is not meant to apply to a country like Ireland, but only a country with its own independent monetary policy and a flexible exchange rate.
On the face of it, this looks too good to be true. But in the topsy-turvey world of the liquidity trap strange things do seem to happen. In this case, though, I do think it is too good to be true.
The key to the expansionary result in Paul’s model is what happens to the exchange rate. Using a standard interest rate parity condition with a risk premium, an increase in the premium leads to a downward jump in the exchange rate. (Essentially, the exchange rate must fall sufficiently to create expectations of future appreciation that are sufficient to maintain the interest rate parity condition.) With nominal rigidities, the nominal exchange rate depreciation is also a real exchange rate depreciation, and hence the expansionary force.
So what then is left out? I think one problem comes with the assumption that that the central bank can still set the domestic interest rate following its usual monetary policy rule (constrained by the zero lower bound). What the stripped down model leaves out is that central bank is only directly affecting the overnight lending rate between banks, and also possibly future expectations of this rate.
This is where the experience of Ireland and other peripheral euro zone economies is relevant. Stressed banks cannot access funding at the central bank’s policy rate. This is what has led to the fragmentation of bank funding markets across the euro zone. The weak creditworthiness of the sovereign is one of the factors affecting the creditworthiness of the banks, as the sovereign remains the primary capital backstop to the banking system. And the high funding costs of the banks is keeping up lending rates to the real economy.
I don’t see a reason why a similar dynamic could not play out in the UK. Even if UK banks are in better shape than peripheral-country banks, a creditworthiness shock to the government would still be likely to affect their funding costs and thus push up borrowing rates for households and firms. How the balance between the expansionary force from the exchange rate and the contractionary force from credit risk would play out I don’t know.
Just to reiterate, this is not an argument that the UK faces a serious risk to its creditworthiness. I find Simon Wren-Lewis largely persuasive on that – even if I can’t help niggling doubts. But if a creditworthiness shock did occur, it seems unlikely that all would be for the best in the real economy.