Author: John McHale

Giancarlo Corsetti and Luca Dedola have a really good VoxEU piece on how cooperation between the central bank and the fiscal authority can avoid the “bad equilibrium” problem for sovereign debt.   The paper on which the Vox article is based is available here; Paul Krugman discusses it here.  

Although the initial focus is on a country with control over its own “printing press”, they also examine how it could work in a monetary union.   I won’t try to summarize the subtle analysis, but the key is how the difference between the interest rates on sovereign debt and central bank reserves can be used to lower the cost of funding below the level that triggers the bad equilibrium.   In contrast to claims that potential central bank intervention has to be unlimited, a central finding is that limited central bank intervention may be sufficient to avoid a bad equilibrium. 

In regard to how it might work in a monetary union, a sting in the tail comes in the last sentence of their closing paragraph.  

The analysis here bears key lessons for the current debate on sovereign default in a monetary union:

·        Countries in a monetary union could indeed be more vulnerable to debt crises, to the extent that the common central bank cannot count on the joint support of national fiscal authorities;

·        The common central bank, however, still has the power to engineer successful interventions.

In doing so, it will have to weigh the benefits and costs of providing a backstop to countries exposed to debt crises, possibly drawing on seignorage accruing to all countries in the union.

“[D]rawing on the seignorage accruing to all countries in the union” raises the familiar political-economy of-transfer-risk problem that has complicated the task of stabilising stressed euro zone sovereign debt markets. 

Apologies for the belated response to Paul Krugman’s post on Ireland (linked to here by Stephen last week).   Paul focuses on Ireland’s poor post-crisis growth performance, noting that real GDP is still well below its peak at the end of the property/credit bubble.   There is no disagreement that the growth performance – and especially the performance domestic demand – has been weak.   This reflects a combination of harsh austerity measures, distressed balance sheets and the weak performance of Ireland’s trading partners. 

This graph extends the real GDP series further back in time.   In judging the continuing shortfall from the peak in 2008, we should not forget the unsustainability of the bubble-driven growth that took place from 2002 onwards.   It is also worth noting that the recent flatness of the GDP graph hides a marked slowdown in net export growth (mainly due to the weak performance of the UK and euro zone economies) combined with tentative signs of a stabilisation in domestic demand (see here). 

But any assessment of Ireland’s progress is incomplete without also looking at this picture.  From early 2010 to mid 2011 Ireland steadily lost its capacity to borrow from financial markets.   It is noteworthy that creditworthiness continued to erode in the months after entering into the Troika programme.   This reflected bad news on fundamentals – notably the size of banking-related losses – but also bad signals about the emerging nature of the euro zone’s lender of last resort in terms of the potential for forced debt restructurings and the seniority of official creditors.   The interaction of better news on the a LOLR (most recently the announcement of the ECB’s OMT programme) and the demonstration that Ireland could meet conditions for official assistance has led to a dramatic fall in borrowing costs.  

Given where we were in mid 2011 – particularly the danger of a default that would have added another vicious twist to the adverse feedback loops that laid the economy low – I can’t see how a fair assessment can leave the creditworthiness developments out.

Following the influential work of Paul De Grauwe and Yuemei Ji, the idea that bond yield crises in the eurozone reflect liquidity (i.e. multiple equilibia) rather solvency has taken hold.   (See, for example, Paul Krugman linking to a post by Joe Weisenthal.)  The main evidence is the synchronised fall in yields when the ECB strengthened the LOLR regime with the annoucement of Outright Monetary Transactions (OMT), and also (indirectly) with the LTRO programme.   This leads to the view that the tough fiscal adjustment programmes are not required for countries to regain creditworthiness.   Here is Joe Weisenthal’s conclusion:

So we can trace the two peaks of Eurozone debt stress directly to two times the ECB intervened. Austerity has had nothing to do with the improvement in borrowing costs.

But is this account too simple?   In one sense I would possibly go even further than De Grauwe and Li: in the context of monetary union, vulnerable countries will not be able to avoid the bad equilibrium without a credible LOLR.   However, I also think it is important to recognise that what is fitfully emerging is a conditional LOLR.    Countries will only get support if they are undergoing required adjustments (OMT description here).   The announcement of OMT would then not help a country if investors believed it would not take the actions that would make it eligible.   The LOLR and the adjustments are then both necessary to prevent or reverse the slide to a bad equilibrium.   

Of course, it could still be argued that the explicit or implicit conditionality is inappropriately demanding (e.g., focusing too much on reductions in the actual deficit as opposed to the structural deficit).    But given the regime as it is, the existence of OMT does not obviate the need for fiscal adjustments to steer clear of the bad equilibrium trap.

Olivier Blanchard and Daniel Leigh provide a good account of the trade-off facing policy makers in identifying the optimal speed of fiscal adjustment.   See also Chapter 2 of the IMF’s recent Fiscal Monitor.   Reasons for slower adjustment include time-varying multipliers, the danger of “stall speed” where adverse feedback loops kick in at low or negative growth rates, and hysteresis effects from fiscal contractions that are worse when the economy is already in recession.   The main reason for faster adjustment is the danger of falling into a bad equilibrium with high interest rates and high expectations of default, especially where it is difficult to credibly commit to future adjustments.  

Simon Wren-Lewis gives a sceptical response here.  Paul Krugman responds here, here and here.  

The debate focuses mainly on the trade-off for a country such as the UK that retains its own independent monetary policy.   In contrast to the uncertainty that surrounds such empirical questions as the size of fiscal multipliers or the causal link from debt to growth, recent experience in Ireland and elsewhere shows that the risk of falling into a “bad equilibrium” is not hypothetical for a high-debt country within EMU.   For fragile EMU members, an additional factor is the existence of a conditional lender of last resort, where one of the conditions for support could be a forced restructuring of privately held debt (PSI).   (I make an initial stab at integrating a conditional LOLR into a model with possible multiple equilibria here)

Interesting proposals here.