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.”