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.