The Anti-Confidence Fairy?

Paul Krugman has provided a new paper and post on the effects of a “sudden stop” of capital inflows in a country with a floating exchange rate and constrained by the zero lower bound on the short-term interest rate.  In previous posts (see here and here), Paul made two claims: (i) that a government operating an independent monetary policy should be able prevent a loss of creditworthiness; and (ii) that even if that loss did occur its effect would be expansionary through a depreciation of the exchange rate. 

He sets out the two issues in the introduction to the new paper:

What I want to talk about instead is a question that some of us have been asking with growing frequency over the last couple of years: Are Greek-type crises likely or even possible for countries that, unlike Greece and other European debtors, retain their own currencies, borrow in those currencies, and let their exchange rates float? 

What I will argue is that the answer is “no” – in fact, no on two levels. First, countries that retain their own currencies are less vulnerable to sudden losses of confidence than members of a monetary union – a point effectively made by Paul De Grauwe (2011). Beyond that, however, even if a sudden loss of confidence does take place, countries that have their own currencies and borrow in those currencies are simply not vulnerable to the kind of crisis so widely envisaged. Remarkably, nobody seems to have laid out exactly how a Greek-style crisis is supposed to happen in a country like Britain, the United States, or Japan – and I don’t believe that there is any plausible mechanism for such a crisis.

I think a lot of people, for differing reasons, found the second claim too good to be true (although I don’t think anyone has in mind quite a Greek-style crisis).  In a couple of earlier posts (here and here) I suggested one contractionary force: a loss of government creditworthiness could impair balance sheets in the banking system.  

In the new paper, which contains some really nice new modelling, Paul attempts to dispose of various objections to the claim that a creditworthiness shock would be expansionary.   (And for the record I am a big Krugman fan.) Here is what writes on the banking channel:

Several commentators – for example, Rogoff (2013) — have suggested that a sudden stop of capital inflows provoked by concerns over sovereign debt would inevitably lead to a banking crisis, and that this crisis would dominate any positive effects from currency depreciation. If correct, this would certainly undermine the optimism I have expressed about how such a scenario would play out.

The question we need to ask here is why, exactly, we should believe that a sudden stop leads to a banking crisis. The argument seems to be that banks would take large losses on their holdings of government bonds. But why, exactly? A country that borrows in its own currency can’t be forced into default, and we’ve just seen that it can’t even be forced to raise interest rates. So there is no reason the domestic-currency value of the country’s bonds should plunge.

But this response essentially just invokes point (i) – that the government with an independent monetary policy won’t lose creditworthiness.   As far as I can see, it does not deal with the second part of claim that the loss of creditworthiness would actually be expansionary even with adverse effects on the financial system at all.   The problem actually comes out more clearly in the original formulation of Paul’s model, where it is explicitly assumed there is a rise in the risk premium – and presumably a reduction in the market value of outstanding government bonds – and it is shown that the effect is expansionary.  

It still seems to me that to dispense with the banking-related objection Paul needs to argue either theoretically or empirically that this particular contractionary force is not relevant.   On the empirical side, the interesting case studies that he looks at do not isolate an answer to the second claim.  

Finally, it is worth considering a simple thought experiment.   Imagine that in the recent imbroglio over the debt ceiling, a solution wasn’t reached and the US government was forced to (temporarily?) default on its debt.   Thinking back to the post-Lehman experience, I don’t think it is hard to imagine that this would be extremely disruptive to the US financial system, notwithstanding a depreciation of the dollar, in ways that would be difficult for the Fed to fully counter in both the banking and shadow-banking systems. 

Comments

comments

26 thoughts on “The Anti-Confidence Fairy?”

  1. “In a couple of earlier posts (here and here) I suggested one contractionary force: a loss of government creditworthiness could impair balance sheets in the banking system.”

    But you never explained how this was supposed to happen. I repeat: 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 chooses.

  2. I think, what the whole Boston crowd (a.k.a. Harward, MIT, and via controlling 60% of professorships in the ivies) conveniently forget, that options available for the US are NOT that pretty much for the rest of the world.

    Discussing the gerneral situation from the outlier point of view.

    Who else, but the US, is controlling 60% of the FX ?

    🙂

  3. @Kevin

    I have tried, but clearly haven’t succeeded.

    You focus on bank funding, supposing that the central bank can provide whatever funding banks need at the policy rate. Putting aside any issues of the central bank’s willingness to provide unlimited funding to banks with large capital holes, bank lending decisions could still be affected by concerns about their ability to attract stable market funding, even if they are reasonably confident that immediate liquidity needs are met.

    Beyond the funding issue, banks with capital holes may attempt to deleverage to rebuild their capital ratios, curbing their lending to the real economy.

    Looking beyond the banks to the shadow banking system, which normally doesn’t have access to central bank liquidity, balance sheets could become severely impaired by losses on government bonds. The 2008 crisis showed how quickly contagion can spread and how this part of the financial system can seize up when important players get into difficulty.

    Given the crisis we have recently lived through, it hardly seems a strong claim to say that the financial system could be impacted by a severe shock to government creditworthiness with knock on implications for credit to the real economy, even where the central bank remains willing to provide ample liquidity to stressed banks.

  4. @John,

    I do appreciate the effort you’re making. My problem is that you seem to be thinking of government creditworthiness as something in the ‘real’ economy, so to speak, which a central bank cannot control. I don’t think that makes sense. If the central bank stands ready to buy 30-year government bonds at a sky-high price, such that the redemption yield is less than 1%, in what sense is the government not creditworthy? In what sense are the assets of the banking system impaired? You refer to losses on government bonds, which simply can’t happen unless the central bank permits it to happen by refusing to buy.

    BTW, following your previous posts on this Simon Wren-Lewis made what seems to me a pretty good effort to find some basis for these worries. His verdict:

    [If] the crisis was big enough, we could overshoot Brad DeLong’s sweet spot, and end up living with a cost-push shock that was more costly than the ZLB constraint. Personally I think this is stretching non-linearities rather too much. First you have to believe that austerity, which reduces debt a bit more quickly than otherwise, is just enough to prevent a crisis, and then that the crisis is so big that it more than offsets the ZLB constraint. Unlikely, but it seems to be a coherent possibility.

  5. From pages 2 & 3 of
    https://webspace.princeton.edu/users/pkrugman/The%20Simple%20Analytics%20of%20Invisible%20Bond%20Vigilantes.pdf

    Equ (2): i = i* + p

    Where p is a risk premium, and following the introduction of own, floating, currency

    At the same time, there will still be interest arbitrage – or better yet, expected return arbitrage – across borders. Using a fairly standard formulation, this might look like the following:

    Equ (4): i = i* + d( e’ – e) + p

    [I’ve used more easily typed e’ instead of e ‘bar’ etc]

    That says in effect:
    Rates in country X = Rates in Germany + Expected devaluation of X’s currency + X’s Risk Premium

    There is a problem at this point since in the real world, with own floating FX, the two terms on the right stop being separate entities in the minds of money weighted investors, and yet Krugman leaves ’risk premium’ there as a discrete item.

    Imagine you are back in the eighties explaining to a board of trustees why you haven’t bought any Italian bonds yielding 8% for them, just German ones yielding 3%. Why aren’t the Italian ones better value? The answer is that compared to the Germans, the Italians have a well established habit of printing and inflating.

    Over time the GDP deflators will likely diverge, and you could expect devaluation losses on your Italian coupons and principle.

    In that example the risk of Italy suddenly converting to a hard money mentality was very small. ‘Default risk’ was small. Currency FX risk was high.

    Thus p in Krugman’s eq (4) was trivial.

    If you introduce a term H to represent country X’s political commitment to ‘Hardness of Money’, so that H = 1 if X is somewhere ultra- Austrian and H = 0 if X is 1980’s Italy, you can include it as an embellishment of eq(4)

    eq (4G): i = i* + (1 – H)d(e’ – e) + Hp

    I think John McHale’s objection hinges on the term p remaining untouched, meaning it is left there – presumably representing risk of hard default on country X’s bonds. This allows the argument “but what about bank balance sheets when perceptions of default risk go up?!” – and Krugman facilitates this in his earlier posts / paper by talking about ‘risk premium’ rising.

    Eq (4G) above would appear to back up this below from P 16 of https://webspace.princeton.edu/users/pkrugman/Currency%20regimes.pdf

    “In short, under current conditions the much-feared loss of confidence by foreign investors would be unambiguously expansionary, raising output and employment in nations like the US, UK and Japan.”

    Provided H was small – and likely to remain so! (see recent debt ceiling politics).

    Also, use of the phrase “the much-feared loss of confidence by foreign investors” is more reflective of reality than simply referring to a “risk premium” and is consistent with the combined term (1 – H)d(e’ – e) + Hp.

    If H is small then “loss of confidence by foreign investors” goes straight through to a lower FX rate, which is more believable than the idea of increased risk premia driving down the FX rate to a point where it is then expected to appreciate to compensate for the increased risk premium. FX going down because it is expected to go up is not a commonplace in my experience.

    I think Krugman should finess this argument and put it to Rogoff & co.

    BTW from the new paper https://webspace.princeton.edu/users/pkrugman/Currency%20regimes.pdf at page 27 “The right panel of Figure 11 shows the French exchange rate, in francs per dollar, over the period” presumably is an error with the FX rate seems the wrong way around.

  6. We are not being ignored.

    arstechnica.com/business/2013/10/meet-the-grand-architect-behind-irelands-tax-avoidance-policy-for-tech-firms/

  7. I propose a new internet blogging law!

    I shall call it ‘DOCM’s Law’!

    It states that in any discussion of a Central Bank’s ability to lend as much as it chooses the longer the discussion continues the probability of Zimbabwe being mentioned approaches 1.

  8. @ GK

    It is the best way I can think of of making the point, as a simple layman, that in any system of fiat currencies, the idea that a central bank of a particular country can lend without limit without disastrous consequences is simply nonsense.

    The owner of the world’s reserve currency may prove the point.

  9. @ DOCM

    I think though, going straight to ‘Zimbabwe!’ isn’t helpful as this isn’t actually what is under discussion: I don’t think anyone above or in the links is suggesting that a central bank of a particular country can at all times and in any circumstances lend without limit without disastrous consequences. The question is, in what circumstances can the CB do so.

    So from one of the Krugman posts: ‘The Confidence Gnomes’

    “What’s more, we have a clear recent example of just how important it is to think these things through. Remember that people like Greenspan insisted that budget deficits would lead to soaring rates and inflation. But they never explained how this was supposed to happen in a depressed economy with zero short-term rates. Again, their logic was more or less

    1. Deficits
    2. ?????
    3. Zimbabwe!

    Meanwhile, those of us who tried to think it through concluded that nothing of the sort would happen — and it didn’t.”

    http://krugman.blogs.nytimes.com/2013/10/28/the-confidence-gnomes/?_r=0

  10. @Kevin

    Just to reiterate, I am focusing on the second claim: that a creditworthiness shock to the government — if it occurred — would be expansionary. Paul’s original challange was to identify a contractionary force that would move in the opposite direction to the expansionary effect of a depreciation.

    I am broadly convinced that a government borrowing in its own currency and able to conduct an independent monetary policy should be able to avoid the creditworthiness shock to begin with. However, I don’t think even this is as clearcut as sometimes stated. See the first link below to the Corsetti and Dedola work below. Antonio Fatas has also been doing some interesting blogging on that broader question (second link below).

    http://www.voxeu.org/article/euro-foreign-currency-member-states

    http://fatasmihov.blogspot.ie/

  11. From pages 2 & 3 of
    https://webspace.princeton.edu/users/pkrugman/The%20Simple%20Analytics%20of%20Invisible%20Bond%20Vigilantes.pdf

    Equ (2): i = i* + p

    Where p is a risk premium, and following the introduction of own, floating, currency

    At the same time, there will still be interest arbitrage – or better yet, expected return arbitrage – across borders. Using a fairly standard formulation, this might look like the following:

    Equ (4): i = i* + d( e’ – e) + p

    [I’ve used more easily typed e’ instead of e ‘bar’ etc]

    That says in effect:
    Rates in country X = Rates in Germany + Expected devaluation of X’s currency + X’s Risk Premium

    There is a problem at this point since in the real world, with own floating FX, the two terms on the right stop being separate entities in the minds of money weighted investors, and yet Krugman leaves ’risk premium’ there as a discrete item.

    Imagine you are back in the eighties explaining to a board of trustees why you haven’t bought any Italian bonds yielding 8% for them, just German ones yielding 3%. Why aren’t the Italian ones better value? The answer is that compared to the Germans, the Italians have a well established habit of printing and inflating.

    Over time the GDP deflators will likely diverge, and you could expect devaluation losses on your Italian coupons and principle.

    In that example the risk of Italy suddenly converting to a hard money mentality was very small. ‘Default risk’ was small. Currency FX risk was high.

    Thus p in Krugman’s eq (4) was trivial.

    If you introduce a term H to represent country X’s political commitment to ‘Hardness of Money’, so that H = 1 if X is somewhere ultra- Austrian and H = 0 if X is 1980’s Italy, you can include it as an embellishment of eq(4)

    eq (4G): i = i* + (1 – H)d(e’ – e) + Hp

    I think John McHale’s objection hinges on the term p remaining untouched, meaning it is left there – presumably representing risk of hard default on country X’s bonds. This allows the argument “but what about bank balance sheets when perceptions of default risk go up?!” – and Krugman facilitates this in his earlier posts / paper by talking about ‘risk premium’ rising.

    Eq (4G) above would appear to back up this below from P 16 of https://webspace.princeton.edu/users/pkrugman/Currency%20regimes.pdf

    “In short, under current conditions the much-feared loss of confidence by foreign investors would be unambiguously expansionary, raising output and employment in nations like the US, UK and Japan.”

    Provided H was small – and likely to remain so! (see recent debt ceiling politics).

    Also, use of the phrase “the much-feared loss of confidence by foreign investors” is more reflective of reality than simply referring to a “risk premium” and is consistent with the combined term (1 – H)d(e’ – e) + Hp.

    If H is small then “loss of confidence by foreign investors” goes straight through to a lower FX rate, which is more believable than the idea of increased risk premia driving down the FX rate to a point where it is then expected to appreciate to compensate for the increased risk premium. FX going down because it is expected to go up is not a commonplace in my experience.

    I think Krugman should finess this argument and put it to Rogoff & co.

    BTW from the new paper at page 27 “The right panel of Figure 11 shows the French exchange rate, in francs per dollar, over the period” presumably is an error with the FX rate seems the wrong way around.

  12. Krugman does not give enough (or any!) attention to the potential impact of deposit flight on the domestic banking system in his analysis. It is not possible for the national central bank to offset deposit flight unless it has near-perfect information about the quality of the domestic bank’s balance sheets, which is not possible.

  13. @grumpy

    Thanks for that interesting analysis.

    I think your concern can be more easily incorporated into the arbitrage equation by allowing for an expected change in the (long-run) equilibrium exchange rate (e bar), say because the two countries have different trend growth rates in money supply and consequent inflation.

    This does bring us back to the issue of “default” via money printing and inflation rather than outright default. Some commentators have expressed reservations about the value of being able to run an independent monetary policy in terms of avoiding interest rate increases when expectations of money printing to avoid outright default are factored in. In the extended arbitrage equation, an expectation of using monetary policy (and consequent inflation) to avoid default would lead to an expectation of depreciation in the equilibrium exchange rate, requiring the nominal interest rate to rise to maintain the arbitrage condition, even with no change in the risk premium. This would again lead to capital losses on outstanding bonds, and potentially again impair balance sheets in the financial sector.

    This is why I find the Corsetti and Dedola analysis so interesting. They examine how monetary policy (or more percisely cooperation between the monetary and fiscal authorities) could avoid default without raising the domestic inflation rate. The analysis hinges on being able to reduce the interest cost on outstanding debt to the consolidated government (including the central bank). By improving the underlying solvency of the government, the creditworthiness of the government is maintained without inflation, and thus without the trend deterioration in the equilibrium exchange rate.

    I think Paul Krugman also sees another difference between regimes where the country has its own central bank and where it doesn’t. If I understand him correctly, he accepts that the use of monetary policy to avoid default could be inflationary (at least outside the liquidity trap). But he assumes that if a country actually has to bear the fixed costs of default it is likely to default big. Thus, while investors are aware of the inflation and associated nominal interest rate risk under and independent monetary policy, they are more fearful of large losses from outright default. Thus, countries with control over their own monetary policy are a better bet despite the inflation risks.

  14. @Gavin Kostick

    On the law of loose money equaling death.

    Hyperinflation in Zimbabwe was a result of the collapse of the Zimbabwean economy (and state) and not a cause of it and our good friend climate change played a substantial part in making Zimbabwe’s situation so dire.

    Shame, very beautiful country and lovely people for the most part (though the racism on display from many White Zimbabwean’s 15 years ago would turn your blood to ice).

    Interesting note on intellectual progress (or lack of it) on the right: It was not so long ago that it was Weimar Germany that was used as the terrifying example of what happens when you become economically unserious before economic historians decided that that too was more a result of a damaged economy than a cause of it. Austerians have close to a century of being wrong about everything. Tools.

  15. “I think your concern can be more easily incorporated into the arbitrage equation by allowing for an expected change in the (long-run) equilibrium exchange rate (e bar), say because the two countries have different trend growth rates in money supply and consequent inflation.”

    I think you need to address the fact that the nature of the ‘risk’ that you are pricing for as an investor if very different depending on whether the authorities in question have a ‘hard’ or ‘soft’ money mindset. I think your concern and probably Rogoff’s, about banks’ holdings of local currency government bonds hinges on the “risk premium” not tending to zero – hence “loss of confidence -> lower bond prices.

    In reality though, once investors are convinced that (i) there is a local soft money mindset (ii) there is little prospect of that changing (iii) own floating currency (iv) own central bank then essentially ALL the ‘risk’ becomes currency depreciation risk.

    Explicitly allowing ‘H’ or some equivalent to set default risk to near zero will stop you and Krugman and Rogoff, the GOP and Osborne etc disagreeing about the consequences for bank solvencey when printing your own currency to buy bonds in a liquidity trap if foreiners stop doing so.

  16. Poor old Paul. He predicted the collapse of the euro, what is it three years ago? Not looking very likely now.

    Maybe a Greek style crisis is not possible outside a monetary union. What exactly did the monetary union contribute to that crisis and our own? It allowed Greeks and ourselves to borrow almost unlimited amounts of hard currency on the false market premise that we were as creditworthy as the Germans. That possibly will never happen again, remember that the euro experiment is unique in history, we live and learn. But as John’s thought experiment reminds us even worse but possibly different crises can happen outside a monetary union. So what, Paul?

  17. After Gavin invoked the Zimbabwe law, let me bring here the weak version of Godwin’s law.

    @ Shay,

    the straw man Weimar works in multiple ways.

    The intelligent people in Germany, who can influence things, know very well that the hyper inflation was 1923, and the depression started in 1929.

    What we are afraid of here , is the very real experience, in our own life time, of this runaway inflation in Italy and most other southern countries after the break down of Breton Woods 1973 (5600 Lira/DM until final 1000 ) . Getting hard candy as change, instead of coins, of which the material was worth a lot more than the nominal. We were getting at the end of every summer vacation rid of all the valuta because of likely devaluation. You should find a respective Asmussen / Lira quote somewhere.

    The endless, Goebbels like, repetition of the hyper inflation straw man, does not make it true either way.

    Adenauer asked 1950 Röpke “Ist die deutsche Wirtschaftspolitik richtig”. And the answer was then and is now : yes, no matter what the Bastonians say. We are, in a very broad consensus, very confident in this.

  18. @grumpy
    Very interesting. If only the real world of money would work so symmetrically….! Random elements (fear, lack of alternative options /relative strengths, market control [of FX /other], etc) also impinge to make it much more interesting!

    How does demand /supply reflect in your equation?

  19. It’s foolish to use Greece’s woes as an example of what could happen the US. However, EMU member countries and the US do share the same protection from currency movements when it comes to public debt.

    Debt owned by the public ex Federal Reserve debt was $10tn at the end of 2012; foreign holdings of US Treasury debt was at $5.6tn – – a ratio of 56.2.%. In 2012, 47.4% of China’s reserves of $3.34tn were invested in US public and private securities and shares.

    So China is exposed to the currency risk.

    In the periods before the bailouts of Greece, Ireland and Portugal, foreign ownership of public debt was in the 70 to 80% range but almost all of it was in euros.

    In respect of the 20 sovereign defaults since 1997 – Mongolia, Venezuela, Russia, Ukraine, Pakistan, Ecuador (twice), Turkey, Ivory Coast, Argentina, Moldova, Paraguay, Uruguay, Domenica, Cameroon, Grenada, Dominican Republic, Belize, Seychelles and Jamaica – Moody’s concluded:

    1) While defaults are correlated with rising debt burdens, a high debt-to-GDP ratio is neither a necessary nor a sufficient condition for sovereign default.

    2) Past defaulters had high foreign currency exposure, an average of 76% of total debt was in foreign currency in the year prior to default, and high debt servicing costs.

    3) Sovereigns with moderately low debt levels have defaulted when their economic prospects were poor, their net foreign currency exposures were large, and their political institutions were weak.

    4) Conversely, countries with high economic resiliency, debt that is predominantly denominated in domestic currency and strong political institutions have historically been successful in managing relatively large debt burdens and eventually reversing increases in debt-to-GDP ratios caused by macroeconomic shocks and banking crises.

    In the case of Iceland with its strong food resource base and capacity to produce five times its local electricity consumption, it remains hampered by capital controls and reduced standards of living.

    Ireland outside the euro, with a high dependence on imported inputs and a small indigenous sector to avail of currency depreciation, would have got inflation but little upside benefit (some would argue that the bubble would have been less severe ex-the EMU. There was a big carry-trade that would have too big a temptation for the politicians and their crony capitalists).

    In the US, on one Thursday in August, when weekly jobless benefit claims were reported to have fallen sharply, markets fell because of fear that the Fed would reduce bond purchases but possibly a lot of the people involved support small government and low or no taxes!

    These are people who have some education.

    What of the typical voters? – according to a Washington Post analysis, the local economies of 45 hardline House Republicans are performing worse than the national average.

    People there blame Obama for high debt etc.

    So all that feeds political gridlock but as John McHale has pointed out, it likely also impacts bank credit decisions across the country.

    New startups for example are very important for an economy and funding normally comes from: personal funds, relatives, credit cards and banks.

    At the other end of the scale, 5 US tech firms held $515bn in cash or near-equivalent at the end of June.

  20. What is the capital flow shock takes the form of a withdrawal of direct investment as opposed to portfolio inflows. Would that not reduce incomes and shift the IS curve leftward initially and that might offset any rightward shift on the back of a weaker exchange rate, particularly in a relatively closed economy like the US?.

  21. Thinking about the above from John again, for me, his use of “creditworthiness” should again be replaced with “credibility”……quite a different concept, obviously.

    I don’t see the inevitable link between a government’s creditworthiness and indigenous banks’ creditworthiness in an increasing globalized world, even if globalization has taken a current, large (but likely temporary) step backwards. That said, government backing of an insolvent banking system clearly can lead to insolvency of the former, as in Ireland’s case. However, that is neither inevitable nor even automatic. It is /was choice, largely in favor of maintaining a status quo which is /was unsustainable. That is where I diverge from John’s analysis /apparent line of economic belief……but he and th Fiscal Council operate also in a political context…..

    That said again, is it right to continue to analyze Ireland as a separate economic entity anymore….? There is no local solution without a macro (at least EU /Eurozone) solution…..(one could even argue Global Solution, as the US indicated today with criticism of China and German current surpluses).

    What is galling though to witness is the endless economic “sermon” from Ireland’s Establishment that there is only one way……and John, you apparently are in that rut…..disappointing result despite the Harvard education. For me, you need to do better, be more original, creative…..actually, effective (if you can be?….). How are you /the Fiscal Council making things better? If you were a Chairman or CEO in the private sector, you would have to deal with that issue more directly. So far, that has not been the case.

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