Paul Krugman on Expansionary Creditworthiness Shocks

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.  

22 replies on “Paul Krugman on Expansionary Creditworthiness Shocks”

Um. I don’t think this is quite right. If the central bank is maintaining a low policy rate, then stressed banks would as a last resort be able to borrow at close to that rate directly from the central bank. After all, there is no reason for the central bank to charge market rates for secured borrowing using pre-positioned collateral, and if it is intent on maintaining a low policy rate in the face of market determination to push up yields it could offer funding to banks at far more favourable terms as a means of bringing down market rates. The real problem is that the central bank might not be able to maintain a low policy rate if yields on sovereign debt are rising due to lack of sovereign creditworthiness. But as Simon Wren-Lewis pointed out, the central bank can buy enough sovereign debt to push yields down.

what I wonder here about,

is the words like “attack” or “shock” for something I see way more like a gradual loss of confidence, based on the continued reckless behavior of dysfunctional polities.

From my perspective, OMT provides a very lethal hammer against any speculative attack, as like some Paul Krugman provided the analytical war strategy for in his 1979 “A balance of payment crises”,

while maintaining “strict conditionality” to insure the “no bail out, no money printing” principles as the bedrock of European Stability culture.

“Stressed banks cannot access funding at the central bank’s policy rate.”

There was more to it than that. What was the backstory ? NAMA was ridiculous. No other peripheral country followed Ireland’s NAMA lead. Debt for equity would have been far more effective. But the PTB wouldn’t hear of it.

There’s more than one answer to these questions….

In January 2012, the yield on 10-year British gilts dropped to a record low of 1.92%, which was below the previous low of 1.96% recorded in 1897 and the lowest level since Bank of England records began in 1703.

In July France joined Eurozone countries such as Germany and the Netherlands in selling short-term debt at negative interest rates.

So as the euro crisis deepened, the European economies that had relatively stable economies but budgetary problems such as the UK, France and the Netherlands, were seen as safe haven locations.

In May 2010, it is very likely that the chancellor of a reelected Labour government would have proposed broadly similar fiscal measures to those presented by George Osborne, the current incumbent.

There were a lot of unknowns and the first half of a parliament was the time when governing parties would make unpalatable decisions.

It was unclear how financial services, a key export sector for the UK, would develop while in manufacturing, the UK compared poorly with Germany in emerging markets.

The euro crisis was responsible for a poor performance by UK exporters in recent years.

The current account deficit rose from 2.5% of GDP to 3.7% in 2012.

Spending in real terms rose from £694bn in 2008/09 to £716bn, £720bn, £705bn and £675bn in 2012/13.

Capital spending dropped by £110bn over the period to £43bn.

Public spending as a share of GDP was at 36.6% and 44% in 2006 and 49% in 2012.

Private sector debt as a ratio of GDP [pdf] was 250% in 2000, 460% in 2010 and about 440% in 2012.

General government debt was 79% in 2010 and 94% in 2013; the deficit was -10% and is expected to be 7.1% this year.

The pre-crisis rise in spending in 2000-2007 was financed by debt.
The Bank of England purchased £375bn worth of bonds – – about 30% of public debt.

The austerity was mild and it’s not clear what impact a stimulus would have had. The trade-weighted fall in sterling of over 20% brought a rise in inflation. lower real wages and no export miracle.

Real wages have fallen while private sector employment has risen by 1.3m to a record high of 24.1m since 2010 – – while public sector employment has fallen by over 400,000.

The Office of National Statistics said last September: “The number of men in work for May to July 2013 was 15.95m, virtually the same as five years previously. However the number of men working full-time fell by 272,000 to reach 13.85m, while the number of men working part-time increased by 281,000 to reach 2.10m.

The number of women in work for May to July 2013 was 13.89m, 318,000 higher than five years previously. “This increase in female employment over the last five years was almost entirely due to part-time employment,” the ONS said.

@Frances C

You do not address the fact that banks in countries in the euro zone with stressed sovereigns are still facing relatively high average funding rates and charging relative high interest rates on loans, even though they have access to cheap central bank funding. This includes cheap longer-term funding through the LTROs. Collateral constraints may limit access to central bank funding, but there also seems to be an unwillingness to rely too heavily on central bank, possibly because of implications for their ability to raise non-collateralised funding from non-official sources.

It is interesting that OMT has been officially sold as a policy to fix the broken transmission mechanism, and in particular to remove perceived tail risks of a euro zone break up. But, though the ECB doesn’t want to put it this way, I think the ECB knows that it won’t be able to fix the transmission mechanism — that is, reduce the borrowing and lending rates of banks in a uniform way across the euro zone — unless the sovereigns are robustly creditworthy. This goes beyond the risk of break up.

I don’t see why the same issues couldn’t arise in the UK if the state faced a large negative creditworthiness shock. Just to stress again, this is not an argument about the liklihood of such a shock. The issue is whether such a shock, if it did occur, would be expansionary. Paul attains the expansionary result from assuming that the rates at which the private sector can borrow are unaffected. The euro zone experience should give some pause.

John McHale: “I don’t see why the same issues couldn’t arise in the UK if the state faced a large negative creditworthiness shock.”

Well sure it could happen, if the Bank of England chose to behave like the ECB, supporting banks only grudgingly and sometimes even threatening to cut them off if “their” government won’t bow to its will. Obviously Krugman is assuming, quite reasonably, that the Bank of England wouldn’t try to mount a coup.

Unless Trichet is appointed Governor of the Bank of England I’d say your scenario is not one to be taken seriously.

@ MH: Not a pretty ‘picture’.

” … trade-weighted fall in sterling of over 20% brought a rise in inflation. lower real wage …” This will not goose energy costs?

“Capital spending dropped by £110bn over the period to £43bn.” How much went into ‘financial products?

” … the number of men working full-time fell by 272,000 to reach 13.85m, while the number of men working part-time increased by 281,000 to reach 2.10m.”

“[This] increase in female employment over the last five years was almost entirely due to part-time employment,”

So PT work is the new thingy?

And the above list of economic negatives, if they persist for some time, will bring ‘positive’ growth then? “Well, they will in their glue!”

Ok, so can someone – anyone, please explain how a consumer-led economy (aka: a demand-led economy) can ‘recover’ and resume its upward-only exponential growth trend given the above? It cannot. Period!

So, lets crank up a supply-led economy then! Opps – that means more virtual money creation, more credit … and another layer of debt overburden. At what point does one become unhinged from this lunacy?

Anyone read Donal Donovan’s Op ‘piece’ in Sat IT? Unbelievable stuff.


I think you are mixing things up. The liquidity support provided to euro zone banks by the ECB has been far from grudging. But ultimately the solvency of the banks matters for their ability to raise low cost market funding. And, as we have seen, the solvency of the sovereign matters for the perception of the creditworthiness of the banks. You may put other sins at Trichet’s door, but failure to provide liquidity to solvent banks does not strike me as one of them.

“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. ”

I suppose it depends on what’s happening elsewhere and how panicked the markets are. Most of the western economies are compromised in some way or other but one of the amazing things about all the money sloshing around looking for a home is that it has to be invested somewhere. And if yields rise the assets become attractive to specialist funds. No growth raises yields to a higher art. Some of the dynamics of the crisis have been very interesting. There’s a touch of Pavlov’s dogs about the whole thing.

“The liquidity support provided to euro zone banks by the ECB has been far from grudging.”
well, unless you count “take the losses pixyheads or we (might but wont say, coz were coy and shy) will think again about this liquidity support” …..

I don’t think “solvency of the sovereign” is a very meaningful concept when the exchange rate is floating. I’ve never heard of a state with a floating currency being declared insolvent. You hop from “the solvency of the banks” to “their ability to raise low cost market funding” and from there to the perception of their creditworthiness in the space of two sentences. This looks to me like John Holbo’s two-step of terrific triviality. Of course bank solvency matters. If the UK banks are insolvent then they should be put through some form of resolution process. If they are not, then the Bank of England can give them low-cost funding until it comes out their ears. It doesn’t much matter whether they are shunned by their international peers for a time.

@ John McHale

First a big compliment for pointing to this Krugman piece and this blog in general. In Germany we are in general somewhat stingy with compliments, “net g’schmipft is gut gnuag” (No scolding is enough of praise : – )

Given the context, and after googling “economics Frances C” I assume I was meant here.
It actually turned up a nice link, hinting to another worthwhile blog : – )

And I hope, that providing this link, together with “Stupid but constitutional”, I nearly spilled some coffee over in the morning, is enjoyed by some readers, WITHOUT diverting the discussion here.

I am male, located in Dresden, and I will not reveal my identity on principle. People shall judge me on my arguments.

Having this out of the way,
could you provide some, preferable quantitative, source for the “relatively high average funding rates”, you are looking at?

It is indeed very interesting what instruments are sold to what constituency in which way, when.

I perceived the LTRO to some degree as some stealth QE, adjusting European rates, especially FX, to what the FED is doing, because exchange rates above 1.4 to the Dollar, as from the 4Q2010 on, would have killed industry in the weaker parts of the EuroArea (EA). The same very legitimate reason, like the Swiss pegging to the deutschmark, like in 1979 and from 4Q2011 on

I cannot see how John McHale can be wrong on this one. If he is, I must be watching the wrong European movie.

Creditworthiness – whether of banks or sovereigns – is a subjective rather than objective concept. The euro in its early days was posited on the mistaken assumption that mutualisation of sovereign credit risks already existed. Experience has shown that this is not the case; far from it. This was a major political error based on faulty economics. The negotiation now, it seems to me, is about defining where the borderline between national and central responsibility lies or, as Merkel puts it, “assistance in return for strong conditionality”.

On the UK, if the banks are overextended and the sovereign is also (a budget deficit on par with that of Ireland?), the possibility of something going awry, even allowing for the changes with regard to currencies, must surely exist.

@ All

Herewith a link to a comment in a German newspaper (which should meet all circulation figure requirements).

It is of great interest in several respects, notably with regard to establishing where the borderline between national and central (EU/EA) responsibility lies and whether the route being pursued is compatible with IMF rules.

@ John McHale

Sorry for the delated reply.

The EBRD box is indeed pretty outdated. It describes the situation pre OMT in July 2012. The corporate interest rates are a reflection of the national risks, pretty accurately. From that point of view, that’s history now.

I got delayed by (checking my) stitching together my data series, which had breaks at precisely that point. I wonder why, …. ROFL.
I enjoyed

Soros is active on the Spiegel again, but no sight of Citi Buiter, or de Grauwe on voxeu, yet.

Could it be, that Ken Rogoff just delivered the opening salvo on the independent British Pound?

After it became clear, that the capital of the ESM is not tied down to specific places, (as Soros and others tried to) and provides a small (500 bn) precision goldsmith hämmerli, keeping intact the wording of the European treaties, and a huge Krupp forge OMT is just waiting after that,
According to the glowing FT, Paulson tries now his hands on greek banks, after getting burned somewhat on his Romanian gold mine : – )

Does Soros stage a second run on the Bank of England?

The Euro members are protected by the financial fire power of a whole continent. Not the English.

“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.”

Unless I misunderstand the point, if this was a problem, couldn’t the BoE start an LTRO program to lower bank funding costs?

LOL, I ll do realize, that their was a frances C in this blog and I was probably hard to understand to some, without the following thing,

which is not in the model, and I also did not say, but immediately think.

When people lose trust in your creditworthiness, then you have to pay upfront for some of your imports, things made to order, etc., and suddenly you need foreign reserves, like EM countries, which you can not built with a Current account deficit

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