Giancarlo Corsetti (University of Cambridge, ADEMU and CEPR) reviews the downturn of the euro area and the role of monetary policy in the government debt market in the sixth ADEMU perspective.
At the time of the writing, in the second quarter of 2017, the euro area as a whole is showing some reliable signs of recovery, although unemployment rates and economic activity still differ substantially across borders. This is in contrast to other regions of the world, especially the US, which have already been operating near full employment for some time.
There may be different views on what explains the longer and deeper downturn in the euro area. But there is little doubt that a fundamental role was played by the sovereign risk crisis that, starting in 2010, led to deep fragmentation of the economic and financial space across national borders – to an extent that is not remotely comparable with the asymmetric impact of the crisis across regions in other countries, say, counties and states in the US.
The sovereign risk crisis specific to the euro area effectively amplified the economic and social costs of the global crisis in the region, well beyond what conventional economic and political models could foresee the time. Take the Optimal Currency Area literature. Virtually all contributions in this are stress the costs of asymmetric exogenous demand disturbances in unions that lack instruments to stabilize them and share risks via market diversification or fiscal arrangement. The experience in the euro area suggests a different, and far more consequential, problem.
In a single currency area lacking appropriate institutional and policy development, any fundamental weakness specific to a country can become the premise for disruptive liquidity squeezes, acting as endogenous disturbances. Fundamental and self-fulfilling factors, as well as country-specific and systemic dimensions of the crisis, become strictly interwoven. Under economic and fiscal stress, institutional and policy deficiencies become them self a source of continuing policy conflict and destabilizing disturbances. ‘Completing’ the union means first and foremost addressing this issue.
In 2012, two significant steps towards institutional development of the euro area – the institution of the European Stability Mechanism (ESM), and the ECB’s Outright Monetary Transactions (OMTs) programme – marked a turning point in the managing of the crisis. Together, they effectively prevented a dangerous unravelling of financial turmoil fed by widespread doubts about the resilience and integrity of the euro area. As expectations of a euro-area break up and/or sovereign default appeared to be to a large extent self-fulfilling, they raised the need of a coordinated, credible and systemic policy response, providing a reliable backstop to government debt in the area.
The problem of self-fulfilling sovereign crises
The theoretical mechanism by which self-fulfilling sovereign risk crisis develops has been worked out by a number of contributions (see Calvo 1988 and Lorenzoni and Werning 2013 among others). For a sufficiently high level of debt, the equilibrium price of a country’s debt may not be unique: markets may then coordinate their expectations on wither relatively ‘good’ or relatively ‘bad’ equilibria – the latter characterized by higher and more likely default than the former. When markets coordinate expectations on equilibria with more default, they charge a high interest rate on government bonds. The increase in the cost of servicing the debt (a higher interest bill), in turn, creates incentives for the government to default ex post, rather than implementing highly distortionary budget cuts – validating ex post the initial markets’ expectations.
An equilibrium with this type of default is considered non-fundamental, in the sense that, relative to other possible equilibria, the equilibrium interest rate on debt is higher, default occurs in more states of nature and tax and inflation distortions are more pervasive –hence social welfare is lower.
The importance of these dynamics for the euro area crisis was soon understood. In 2012, the Governing Council of the ECB wrote:
“the assessment of the Governing Council is that we are in […] a “bad equilibrium”, namely an equilibrium where you may have self-fulfilling expectations that feed upon themselves and generate very adverse scenarios. So, there is a case for intervening, in a sense, to “break” these expectations, which, by the way, do not concern only the specific countries, but the euro area as a whole.”
Why were countries in the euro area vulnerable to sovereign risk crisis, to an extent that was not experienced by virtually any other advanced country? An answer was provided by the ECB president Mario Draghi, in his Luncheon Address: Unemployment in the Euro Area, during the Jackson Hole Symposium, August 22, 2014:
“Public debt is in aggregate not higher in the euro area than in the US or Japan. [T]he central bank in those countries could act and has acted as a backstop for government funding. This is an important reason why markets spared their fiscal authorities the loss of confidence that constrained many euro area governments’ market access.”
Somewhat surprisingly, as European policymakers were becoming increasingly aware of the potentially disruptive consequences of this type of crisis and the need for coordinated interventions, there was virtually no academic work providing a systematic and rigorous analysis of the role of monetary policy in belief-driven debt crisis. The one important exception, the seminal contribution by Calvo (1988), is actually concerned with the possibility that monetary policy itself become a source of instability in the sovereign debt market, rather than a solution to the problem.
An analytical framework was required to clarify fundamental questions weighing on the policy debate. First, what are the mechanisms that allow a central bank to provide a monetary backstop to government debt? Namely, would a backstop rest on the ability of the central bank to (threaten markets to) debase debt via unexpected inflation? Alternatively, under what conditions can a backstop be effective without compromising the central bank’s ability to pursue its primary objectives – in the case of the ECB, price stability? These questions are at the core of the ADEMU working paper by Giancarlo Corsetti and Luca Dedola (Corsetti and Dedola).
The ‘mystery of the printing press’
In order to understand monetary backstop, it is important to recognize that default can occur either via outright haircuts and/or inflationary debt debasement, or both. And these are decisions taken by policymakers facing with trade-offs between increasing tax and spending distortions in servicing a large debt costs, or sustaining the costs of repudiation and inflation.
Building on Calvo (1988), Corsetti and Dedola (2016) set up a stylized model where welfare-maximizing fiscal and monetary authorities optimally choose their policies under discretion. Ex post, when setting taxes, the fiscal authorities may choose outright repudiation on its debt and impose losses (haircuts) on bondholders. Monetary authorities set inflation generating seignior age and reducing the real value of debt. Most importantly, in addition to pursuing (conventional) inflation policy, monetary authorities can engage in (unconventional) balance sheet policy, through outright purchases of government bonds.
A first important contribution of the analysis consists of clarifying the mechanism by which a central bank can provide a backstop to government debt. This essentially rests on unconventional balance sheet policies, and has the same theoretical foundations of a lender of last resort: for a backstop to be successful, it must be the case that the (monetary) liabilities issued by the central bank pays a lower interest rate than a government subject to default risk. So, when the central bank buys government bonds, it essentially swaps (default-) risky government debt with nominal liabilities that are risk-free in nominal terms—as they can always be redeemed against currency. By virtue of this interest differential, central bank’s purchases of public debt reduce the overall costs of borrowing for the government. On a sufficient scale, debt purchases can thus lower the costs of borrowing, up to the point of eliminating any incentive for the fiscal authorities to default.
As is the case for a lender of last resort, a backstop policy can prevent crises driven by self-fulfilling expectations without carrying out any debt purchase in equilibrium. The fact that the central bank is credibly expected to intervene in response to a hike in interest rates not justified by fundamentals, is enough to pre-empt rule out any rationale for a run – as arbitrary expectations of default will not be validated ex post. However, for a backstop to be successful, markets must be convinced that, were their to price non-fundamental default in the debt market, the central bank would be willing to carry out its debt purchase policies with sufficient determination. It must be the case that, in such circumstances, interventions in the debt market on a sufficient scale would be not only feasible, but also desirable (i.e., welfare-improving) from the vantage point of monetary policymakers.
A key problem with the credibility of backstop policies is that eliminating self-fulfilling default does not necessarily eliminates default altogether, which may still occur for fundamental reasons (e.g., a deep recession). If only off-equilibrium, central bank purchases may end up generating balance sheet losses. Fearing that these prospective losses would force them to run suboptimal inflation, monetary authorities may then be reluctant to engage in backstop policies, undermining their credibility. In other words, markets would know that, if they run on public debt, the central bank would not intervene for fear of compromising price stability. Two results from our analysis clarify the conditions under which this argument does not apply.
First, inefficient inflation can always be avoided when the fiscal authorities are willing/capable to provide some contingent transfers to the monetary authorities. A “fiscal backing” of the central bank reduces the need to monetize prospective losses: hence it can lower prospective inflation costs well below the welfare gains from preventing beliefs-driven default. To ensure an effective backstop, then, it would be sufficient that the fiscal authorities stands ready to recapitalize the central bank (or not to default on central bank holding of debt), making transfers strictly contingent on the implementation of backstop policies. Again, none of these needs to occur in equilibrium.
What if, by rules or political choice, fiscal transfers to the central bank are banned in all circumstances? A second important result is that prospective high inefficient inflation from central bank interventions can have paradoxically implications for debt sustainability. Specifically, consider the case in which fiscal authorities are themselves sufficiently averse to inflation. In taking their budget decisions, they would fully internalize the high costs from the inflationary consequences of any default. The fact that a haircut on the central bank would have destabilizing effects on price stability will make them increasingly reluctant to default. In these circumstances, budget separation between the fiscal and the monetary authorities would actually strengthen the resilience of the country against self-fulfilling run on public debt.
The key message here is that a high aversion to inflation is not an impediment to backstop policies. Quite the contrary. The analysis in Corsetti and Dedola (2016), indeed, confirms and generalizes the main result in Calvo (1988): if the central bank is not sufficiently credible in its anti-inflationary policies, the country can become vulnerable to belief-driven expectations of both outright default and ‘stealth’ default via inflation. This is because, for any given fiscal policy, inflation rates would not be uniquely determined. Depending on markets coordination, there can be hikes in interest rates and taxation in the presence of sound fiscal fundamentals and no outright default. We show that this scenario is ruled out when policymakers are sufficiently averse to inflation – e.g., when inflation costs are modelled as in the new-Keynesian literature.
Lessons for policy
These analytical results have direct bearing on the policy debate on monetary backstop. By way of example, consider the critical argument according to which the central bank may not have the ability to expand its balance sheet on a sufficient scale to influence the government bond markets, without, at the same time, generating inefficiently high inflation. Or consider the opposite argument, according to which the central bank can freely play the role of lender of last resort to the government because, alternatively, a central bank can always consolidate its liabilities to private banks (i.e. force banks to rollover reserves indefinitely), or debase them by a bout of unexpected inflation.
Consistent with recent literature on ‘new style central banking’, our analysis clarifies that the central bank can expand its balance sheet by remunerating reserves at the equilibrium risk-free nominal rate, without any impact on the price level (whether in or off equilibrium). Moreover, an effective backstop does have to match the full scale of the government financing –its scale must be enough to make default a welfare-dominated option.
The view stressing the option for a central bank to impose financial repression over private banks, de facto introduces the possibility of a form of default on monetary liabilities, without however thinking about its consequences. If the central bank is expected to tamper with its own liabilities, these would no longer be risk free. The logic of self-fulfilling beliefs of default would then apply to a discretionary central bank as well as to the government.
The alternative, inflationary-debasement view downplays the social costs of running high inflation, historically conducive to financial and macro instability. As already mentioned, in line with Calvo (1988), our analysis suggests that downplaying the costs of inflation may actually raise the prospects of self-fulfilling sovereign debt crises driven by expectations of debt debasement, rather than outright default. On the contrary, it is exactly because inflation costs are (perceived to be) socially costly, that a monetary backstop can be credible even when the central bank is responsible for its losses.
Indeed, a non-trivial conclusion from our analysis is that inflation rates are higher in an equilibrium with belief-driven outright defaults: an effective monetary backstop prevents rather than creating price instability.
These arguments apply to both countries with an independent monetary policy, and countries that are part of a monetary union. In a monetary union among essentially independent states, however, the picture may be complicated by the possibility that national governments pursue conflicting, inward-looking objectives and/or be averse to extending large-scale fiscal backing to the common central bank. If the central bank cannot count on fiscal backing, the union-wide inflationary consequences from budget losses due to default by one country may be quite contained. This means that a self-interested national fiscal authority choosing to default may not fully internalize the inflationary costs of its decision. These circumstances do not prevent a common central bank from engineering a successful backstop to member states. However, they highlight the importance to grant governments access to the benefit of a backstop, only provided they agree to conditionality. In this sense, the OMTs are designed to be accessible only to member states already in an ESM program, meant to ensure stability of public finances (and possibly enhance cross-border cooperation).
But while an assessment of opportunistic behavior by the fiscal authority requires a deeper analysis and discussion (see Ábrahám et al. 2017), it is important to emphasize that, conceptually, backstops (eliminating self-fulfilling crises via an off-equilibrium threat of interventions) are distinct from bailouts (providing contingent transfers ex post). There is a long-standing literature emphasizing that backstops actually strengthen the incentives for a government to undertake reforms and implement good policies –the opposite of the “moral hazard” consequences of a bailout (see Morris and Shin 2006, Corsetti et al. 2004 and Corsetti and Dedola 2011 among others). Intuitively, the possibility of belief-driven crises tends to reduce the expected future benefits from current (costly) policy initiatives. For any given cost, an effective shield against self-fulfilling runs strengthens the (political) incentives to implement them.
In conclusion, the smooth functioning of a monetary union crucially rests on mechanisms and institutions providing effective backstop to government debt, with the goal of shielding the member states and regions from disruptive bouts of belief-driven financial turmoil. The OMT programme, in conjunction with the European Stability Mechanism, was without doubt a key institutional development in the euro area. Contrary to some claims in the initial stages of the crisis, the member states of a monetary union do not need to operate at a disadvantage, relative to states with an independent currency. In either case, central banks can effectively contain disruptive speculation in the debt market.
Aguiar, M., Amador, M., Farhi, A., Gopinath, G. (2013) ‘Crisis and Commitment: Inflation Credibility and the Vulnerability to Sovereign Debt Crises’
Ábrahám, Á., Carceles-Poveda, E., Liu, Y., Marimon, R., (2017) ‘On the optimal design of a Financial Stability Fund’, preliminary version, presented at the ADEMU conference on “How Much of a Fiscal Union for the EMU”, Madrid, 18-19 May 2017
Bacchetta, P., Wincoop, E., Perazzi, E., (2015) ‘Self-Fulfilling Debt Crises: Can Monetary Policy Really Help?’
Calvo, G.A. (1988). ‘Servicing the Public Debt: The Role of Expectations’, The Economic Review, 78, (4), 647-661
Camous, A. and Cooper, R. (2014) ‘Monetary Policy and Debt Fragility’
Corsetti G. and Dedola L. (2011). ‘Fiscal Crises, Confidence and Default: A Bare-bones Model with Lessons for the Euro Area’. mimeo, Cambridge University.
Corsetti, G. and Dedola, L. (2016) ‘The Mystery of the Printing Press Monetary Policy and Self-fulfilling Debt Crises’, ADEMU Working Paper Series 2016/035
Corsetti G., Guimaraes B. and Roubini N. (2005). ‘International lending of last resort and moral hazard: A model of IMF’s catalytic finance.’ Journal of Monetary Economics, 53(3), 441-471.
Draghi, M. (2014) ‘Unemployment in the Euro Area’, https://www.ecb.europa.eu/press/key/date/2014/html/sp140822.en.html, last viewed 03/07/17
Draghi, M. (2012) ‘Introductory Statement to the Press Conference’, https://www.ecb.europa.eu/press/pressconf/2012/html/is120906.en.html, last viewed 03/07/17
Lorenzoni, G. and Werning, I. (2013) ‘Slow Moving Debt Crises’, NBER, Working Paper No. 19228
Morris, S. and Shin, H.S. (2006) ‘Catalytic finance: When does it work?’, Journal of International Economics, 70, 161-177
 A number of researchers started to fill the gap, although often restricting monetary policy to rely exclusively on conventional policies, including Aguiar et al. (2013), Camous and Cooper (2014) and Bacchetta et al. (2015).