Some further thoughts on expansionary sovereign creditworthiness shocks

Just a quick follow up to my post questioning the result in Paul Krugman’s model that a sovereign creditworthiness shock is necessarily expansionary in an economy with an independent monetary policy and flexible exchange rates.   I was a little surprised by the ease at which some commentators suggested that questioning this result is absurd.   My suggested extension to Paul’s model is really just the addition of a “balance sheet channel,” but where the balance sheets in question are those of the banks.  The argument for such a channel has been best made by Ben Bernanke.   See, for example, this speech.   An extract:

[T]he cost and availability of nondeposit funds for any given bank will depend on the perceived creditworthiness of the institution.  Thus, the concerns of holders of uninsured bank liabilities about bank credit quality generate an external finance premium for banks that is similar to that faced by other borrowers.  The external finance premium paid by banks is presumably reflected in turn in the cost and availability of funds to bank-dependent borrowers.  Importantly, this way of casting the bank-lending channel unifies the financial accelerator and credit channel concepts, as the central mechanism of both is seen to be the external finance premium and its relationship to borrowers’ balance sheets.  The only difference is that the financial accelerator focuses on the ultimate borrowers–firms and households– whereas financial intermediaries are the relevant borrowers in the theory of the credit channel.

The question then is how a sovereign creditworthiness shock could affect the perceived creditworthiness of domestic banks.   I focused in the previous post on the potential role of the sovereign as a capital backstop for the banks.  But other channels are also potentially present.  The credibility of liability guarantees will depend on the creditworthiness of the sovereign.   Also, to the extent that the banks are holding government bonds, capital losses will erode the banks’ capital. 

There is the question as to whether conventional or unconventional policy could offset contractionary effects of a sovereign creditworthiness shock.   Vasco Cúrdia Michael Woodford, for example, have examined how monetary policy rules should be altered where “financial frictions” are present, though their focus is on borrower rather than bank balance sheets (see here).   But the zero lower bound will presumably limit what even an extended monetary policy rule can achieve.  Maybe QE could help offset the contractionary effects of the induced shocks to bank balance sheets.  (This is separate from the potential role of QE in avoiding the shock to sovereign creditworthiness in the first place.)   But Paul himself has questioned the potency of QE as a stimulus tool.

Update:  Krugman responds to Rogoff’s response here.   (I am spending too much time on this, but it is fascinating.)

I just want to pick up on one point.   Paul asks:

On the economic question at hand, Rogoff seems to be playing bait and switch. Wren-Lewis and I both asked why, exactly, a country like Britain should fear a Greek-style loss of confidence. Rogoff, however, spends most of his piece arguing that Britain would, in fact, be hurt by a euro collapse. Of course it would. So? This doesn’t even seem relevant to Rogoff’s own argument for austerity policies: British austerity might be “insurance” against loss of confidence, but it makes no difference either way to the probability of disaster in Europe. What’s going on here?

Both Paul and Ken agree that a euro collapse would be directly bad for the UK economy.   They clearly disagree on the likely implications for UK creditworthiness.   But there is a further disagreement related to the post above.   If it did occur, Paul believes that the creditworthiness shock would itself be expansionary, and so help offset the direct contractionary impulse of the euro zone shock.   I think Ken believes it would be compounding.   The differences here can affect the perceived value of “insurance.”



14 replies on “Some further thoughts on expansionary sovereign creditworthiness shocks”

“The external finance premium paid by banks is presumably reflected in turn in the cost and availability of funds to bank-dependent borrowers.”

The interests of banks and sovereigns are so intertwined and so damaging that the best solution appears to be to circumvent the lending activities – or rather the lack of them – to SMEs of the latter altogether, a course that Spain is now following. (H/T Eurointelligence).

ot, fyi

Interview With George Soros: ‘Greece Can Never Pay Back Its Debt’
By Gregor Peter Schmitz in Brussels

Should Greece have a large part of its debt waived? Absolutely, says George Soros, otherwise the country will never recover. The billionaire investor also warns about the rise of extremist parties if Germany does not change its policies towards Europe.
[…] Soros recognizes this problem: “The official sector cannot write down its debt because that would violate a number of taboos, particularly for the ECB.” These issues, however, could be surmounted under German leadership.

And if any country were to recognize how such an approach could work, he argued, it was Germany, which “ought to remember that it has benefited from debt writedowns three times, with the Dawes Plan, the Young Plan and in connection with the Marshall Plan.”

Where is the promised growth to come from?

“Imports rose by 0.4%, widening Germany’s trade surplus to €15.6bn (£13.2bn) from €15bn in July – higher than analysts had predicted but below a surplus of €18.1bn in the same month last year.

On an annual basis, German imports were 2.2% lower than in August 2012 while exports of goods were 5.4% lower.”

“The German finance ministry says industrial orders fell 0.3% in August, adding to the 1.9% slide seen in July. Economists had expected a bounce-back.

Overseas orders slid by 2.1%, or 2.9% within the euro region, showing that Germany suffers from the weak demand in other nations. Orders for capital goods (such as large machinery) from other euro members tumbled by 9.2%.

The German economic ministry tried to put a positive spin on the figures, pointing out that demand for capital goods within Germany jumped by 4.7%. That suggests domestic investment activity is picking up.”

Lack of investment in the rest of the euro area seems evident.

If the Bank of England is prepared to lend to Barclays at (say) 1%, why should Barclays pay more in the wake of a shock to the creditworthiness of HM Treasury? Are we to suppose that the Governor is among those shocked? If not, what’s the mechanism? I can see how long-term rates are affected (although the Bank can rig those too if it really wants to), but the short-term rate is entirely under the control of the central bank.

I’m not exactly an MMT man, but I do think those guys have managed to retain a firm grasp of a few simple facts about fiat money which more orthodox economists are wont to obfuscate. For example: in a floating exchange-rate regime, there’s no way to stop a central bank lending as much as banks demand at whatever rate it has chosen. The ultimate constraint here is the central bank’s aversion to inflation. But for obvious reasons, that’s not an argument against Krugman’s claim that a creditworthiness shock is stimulative.

Interesting link dealing with demography and its effect on Portugal before the crash. Ireland, Greece and Spain get a lot of coverage. Emigration and Immigration which are of interest to Ireland also covered.

From your link..
WSJ: Again on Greece with regards to the discussion about debt reduction you are due to have next year, from a legal, statutory point of view, do you see the ESM being able to take losses on principal loans?

A: No. I hear there’s a broad debate out there on debt reduction. I’m not convinced that this is necessary.  One should remember that the official sector is providing financing to Greece on a very long-term basis: the average maturity of the second program is 30 years. Interest rates are extremely low because they are our funding costs plus a  few basis points added, and when you calculate that in net present value terms, that’s the equivalent of a huge haircut. From the Greek perspective there’s a huge grant element in the financing we provide without any budgetary cost for our member states, of course. And it comes from long maturities, low interest rates and the fact that even some of the interest rates are deferred –we have deferral on interest payment for ten years as part of the second program. When you add all of that up it’s a huge grant element. And that’s economically the equivalent of a haircut. I think people have to do their homework and look at it that way. That can go a long way.”

But the Greeks are not satisfied with 30 year loans…they now want 50 years.
I think Klaus is being disingenuous ….
“Many people look at it the way the IMF does because the IMF often provides financing for 10 years and therefore it’s very important what happens 10 years from now. But we provide financing for 30 years. And therefore it’s not that important what happens 10 years from now because we will continue to be there financing the largest share of the debt at very low interest rates. And to look only at the debt ratio is just an inadequate analysis.”

So is mr. Regling telling us that he can finance for 30 yrs at extremely low rates. Yes the ESM can finance now with triple A joint and several guarantees…but are they financing long term debt with short term borrowings?

But then again….was it Keynes that said…in the long run we are all dead.

@ Flj

The key sentence is the following;

“From the Greek perspective there’s a huge grant element in the financing we provide without any budgetary cost for our member states, of course.”

The prospective coalition partners in Germany are now haggling over the reciprocal concessions that will have to be made in order to agree a government programme, the one common element to emerge being a consensus NOT to raise taxes.

Regling is clearly a man on top of his brief. The various academic papers floating around, and the disputes associated with them, seem to me, with the best will in the world, to be of near zero relevance to what is actually being negotiated.

@ Flj

Incidentally, there is also the assumption in Regling’s remarks, it seems to me, that the IMF will fold its tent and leave Europe to its own devices. (It should never have agreed to get involved in the first place. You will recall that Trichet was vehemently opposed as he correctly read the step as Germany fleeing her responsibilities).

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