Month: October 2013

Philip’s posting last week of the new report from the Committee on International Economic Policy and Reform, Revisiting Sovereign Bankruptcy, attracted little comment.   This is a pity as it is an impressive piece of work – clear and well argued.   The focus of the report:

This year’s CIEPR report argues that both the nature and our understanding of sovereign debt problems have changed in ways that create a much stronger case for an orderly sovereign bankruptcy regime today than ten years ago. 

Some belated and slightly wonkish comments after the break. 

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.”

The logic of pursuing a fixed budget adjustment target (rather than a ratio to GDP) was reiterated by Craig Beaumont in last week’s IMF conference call. From the transcript:

MR. BEAUMONT: On the budget, the Fund’s position is that we should allow the automatic fiscal stabilizers to work, which means that you adopt a consolidation path, and then if growth is stronger or weaker, you don’t change the amount of measures that are already working through the system. If, for example, growth is weaker, you don’t adopt more measures because you’ll make the economy even weaker still. Similarly, on the upside, if growth is stronger, you don’t cut back measures, you maintain the same effort as planned.

So that’s the preferred approach to fiscal policy–we would rather adopt a plan and implement it consistently, and then allow some flexibility on the headline deficit if growth turned out to be substantially weaker than expected.

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.