Author: John McHale

The Royal Irish Academy Social Sciences Committee in association with the UCD College of Social  Sciences and Law will be holding a conference on the topic Debating Austerity on October 29-30.  The Keynote Lecture and conference will be held at the RIA building at 19 Dawson Street, Dublin 2.

The Keynote Lecture will be given by Professor Simon Wren-Lewis of Oxford University at 6pm, Thursday October 29 (lecture details below).  The lecture will be chaired by Patrick Honohan, Governor, Central Bank of Ireland.

This will be followed on Friday, October 30 by a full day of sessions debating the experience of austerity in Ireland from a variety of perspectives.

Further information on the conference and registration details are available here.   The admission price for the Keynote Lecture on Thursday evening is €5; admission to Friday’s conference is free.

Keynote Lecture: How to Avoid Austerity

Abstract:

Austerity may be defined as a large fiscal contraction that causes a substantial increase in unemployment. If the government has a budget deficit that is unsustainable, or a debt level that is too high, it is sometimes suggested that austerity is inevitable. For an economy with a flexible exchange rate and debt in its own currency, which includes the Eurozone as a whole, this is simply false. Fiscal contraction can always be delayed until monetary policy can offset the deflationary impact of any fiscal contraction. Unfortunately this is not true for a member of a currency union that requires a greater fiscal contraction than the union as a whole. Even in this case, however, a sharp and deep fiscal contraction will be an inefficient waste of resources. As the macroeconomic theory behind these propositions is simple and widely accepted, the interesting question about the current global austerity is why it has happened.

Simon Wren-Lewis is currently Professor of Economic Policy at the Blavatnik School of Government at Oxford University, having previously been a professor in the Economics Department at Oxford.   He is also an Emeritus Fellow of Merton College.   In September 2015 he was appointed to the British Labour Party’s Economic Advisory Committee.

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. 

Simon has an interesting post on the EU measurement of output gaps and structural budget balances.   See: here.

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.  Continue reading “Revisiting Sovereign Bankruptcy”

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.”

 

 

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.