Author: John McHale

This speech by Mario Draghi is generating some interest in comments.   It usefully puts the ECB’s approach to monetary policy during the crisis in a comparative perspective. 

Some complementary reading: Paul Krugman on euro area macro policy; Simon Wren-Lewis and Antonio Fatas on the dual mandate; Janet Yellen on communication/expectations management at the Fed; and Gavyn Davies on inflation targeting.   On the subject of inflation targeting, this new Vox ebook contains a number of interesting perspectives, including chapters by Stefan Gerlach and Karl Whelan (pdf here). 

Putting questions of immediate political feasibility aside, Simon Wren-Lewis asks in a new post if there is a better approach to establishing a fiscal Lender of Last Resort (LOLR) for the eurozone. 

As Simon notes, I expressed some sympathy for the Commission in a previous post.    The Commission recognises the fragility of the eurozone in the absence of a LOLR.   This follows from the well-know multiple equilibria problem (see here).   There is good equilibrium with low expectations of default and consequent low interest rates, creating a debt sustainability situation that validates the initial expectations.  But there is also a bad equilibrium with high expectations of default and consequent high interest rates, again creating a debt sustainability situation that validates the initial expectations.   In part to develop the political support for a fiscal LOLR to coordinate expectations around the good equilibrium (where it is thought to exist), the Commission has pushed the strengthening of fiscal rules and support programmes for countries in difficulty that lean heavily fiscal (and other) conditionality and intrusive surveillance.   

 Simon usefully asks it there is a better way, while recognising the huge political obstacles at present.   His proposal centres on a significant change in the approach to OMT.   Based on an assessment of debt sustainability by a collective of independent fiscal councils – effectively an assessment of whether a good equilibrium exists – the ECB would commit to the necessary bond market interventions to keep interest rates low.   Assuming no change in its mandate, the rationale for the ECB’s participation would presumably be that it would otherwise be unable to operate a single monetary policy where, without their own central bank capable of acting as a LOLR, many countries in the eurozone are susceptible to falling into a bad equilibrium, with the added risk the entire single currency project could unravel.   One question is whether countries facing debt sustainability concerns would be politically capable of making the necessary difficult adjustments without in the absence of programmes with explicit conditionality.

Another dimension of Simon’s proposal is that the fiscal rules should become more sensitive to the aggregate fiscal stance of the eurozone in the context of a zero lower bound on monetary policy, with the obligation to adopt less contractionary policies falling on countries with stronger fiscal positions. 

It is interesting to contrast this proposal with the recent widely discussed observations of Ashoka Mody on the relative merits of adjustment/assistance and default as a means of dealing with debt sustainability challenges (Morning Ireland interview here).    Ashoka’s view is informed by his reading of history of sovereign defaults as involving relatively low output costs.   A rather different reading of the history is given in this survey of the literature on sovereign defaults.    Moving to a regime with a low default trigger would also make private investors extremely wary of sovereign debt, increasing the fragility of market access.   For the long-term, such a low moral-hazard regime certainly has attractions — but it would be one hell of ride along the way.    

Simon Wren-Lewis has a typically thoughtful post on the European Commission’s approach to fiscal adjustment as set out by Buti and Carnot in a post linked to by Philip a couple of weeks back.   In the context of the zero lower bound constraint on monetary policy, it is hard to disagree with him on the inappropriate aggregate stance of eurozone fiscal policy.  

But I think his discussion neglects an important second dimension of the challenge faced by the Commission (and indeed the ECB).   In addition to being in recession, the fiscal lender of resort (LOLR) function is still a work in progress.   This function has come a considerable way since early 2011, when a hard line on official creditor seniority, and the threat of a low trigger for PSI in future bail out programmes, pushed Ireland  and Portugal – followed not far behind by Italy and Spain – deep into “bad equilibrium” territory.   (Some thoughts from the time here.)   In strengthening the lender of last function, the Commission is constrained by the concerns of stronger countries about the fiscal risks they are taking on, which they see as further aggravated by moral hazard.  

(Sometimes I do wonder if the reluctance on LOLR can be fully explained by conflicting interests.   Although it relates more to banking side, the recent comments – even if partially retracted – by the new Eurogroup head does give cause for concern about the appreciation for the importance of the LOLR for avoiding a serious escalation of the eurozone crisis.)   

The Fiscal Treaty, for example, must be seen as part of the quid pro quo for developing the LOLR.   The ESM – absent some of the more damaging elements of the original proposal – and the ECB’s OMT programme would be unlikely without the strengthening of the rules-based framework.    This must be balanced by the Commission against unwelcome implications of the rules for the aggregate fiscal stance.  

Given their advocacy for a strengthened LOLR, I do think the Commission sometimes gets a bum rap.

The IMF has a useful new paper on the possibility of self-defeating austerity.    Paul Krugman responds here.   The paper shows that fiscal adjustments will bring the debt to GDP ratio down over time relative to a no-adjustment baseline, although the ratio will rise in the short run when the multiplier is greater than one.   For the Irish case, this phenomenon was pointed out in the April 2012 Fiscal Assessment Report from the Irish Fiscal Advisory Council (see Box C, p. 45).   See also posts here and here.    The IMF paper also has an interesting suggestion for setting and monitoring debt targets in cyclically adjusted terms. 

What does economics say about the optimal response to a positive shock to nominal government debt – say an increase due to the costs of funding a bank bailout or an increase that results from automatic stabilisers in a recession?   From many recent statements I have seen, there seems to be something close to a conventional wisdom that the increase in the debt does not have to be reversed.   It is only necessary to increase the primary surplus to pay the interest on the higher debt, or, even better, to fund the difference in the nominal interest and nominal growth rate times the increase in debt. 

The logic for this position comes from Robert Barro’s classic tax smoothing paper (Barro, 1979).   Given that distortions rise non-linearly with the tax rate, Barro shows it is optimal to maintain constant tax rates over time for a given path of government spending.   A surprising implication is that a shock to the debt to GDP ratio should be accommodated in the sense that the ratio should be allowed to rise permanently.   This leads to the optimal debt ratio to follow a “random walk”, allowing the ratio to be pushed around by debt shocks.   (See Section 2 of this paper for a nice exposition.)

But is this result too comforting?   As Simon Wren Lewis has pointed out in a number of insightful posts and papers (see here and here), the result depends on Barro’s assumption of altruistically linked generations.   The result does not hold in an overlapping generations (OLG) model where the interest rate is greater than the discount rate due to the limited concern for future generations.  In this model, optimal debt policy does require that the increase in the debt ratio is reversed, although the optimal timeframe for the reversal can be very long.  (Simon is at pains to note that this should not stop the use of countercyclical policy in a recession.) 

Another critical implicit assumption in the Barro model is that the Government’s creditworthiness is not an issue.   This may be a reasonable assumption for a country such as the US that has its own central bank, which could print money to avoid default in extremis.   But recent experience has taught a hard lesson about the fragility of creditworthiness in an economy such as Ireland’s.   Suppose that the debt to GDP ratio has to be below, say, 80 percent of GDP to ensure robust creditworthiness.   For a given path of nominal GDP, the increase in nominal debt due to the shock will have to be reversed – and possibly quite quickly.   (This does not necessarily mean that nominal debt will actually have to be cut; but increases in nominal debt that would have been feasible due to nominal GDP growth must now be foregone.)  

Finally, the result does not allow for rules on the maximum allowable debt to GDP ratio.   Under the SGP and fiscal treaty, the maximum allowable debt ratio is 60 percent of GDP.   Again, any shock to the nominal debt will have to be reversed, even if the time frame under the rules for bringing the debt ratio to the target can be fairly long. 

The bottom line is not a welcome one.   Nominal debt shocks have to be reversed (eventually), not accommodated.