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Monetary financing does not preclude sovereign default

Most investors take for granted that a government with access to monetary financing cannot be driven to default. However, a new paper by Corsetti and Dedola challenges this belief. Monetary financing incurs costs and, hence, preference for default and self-fulfilling confidence crises are possible. Necessary conditions to rule out self-fulfilling crises include credible caps on government borrowing rates, the ability of the central bank to issue default-free, interest-bearing, and non-inflationary “reserves” (rather than cash), and full coverage of central bank losses by the state budget.

The Mystery of the Printing Press: Self-fulfilling Debt Crises and Monetary Sovereignty
Giancarlo Corsetti and Luca Dedola, Working Paper, April 2013

“The historical record warns against overplaying the idea that a own currency be an easy way out of sovereign default. Outright default on public debt denominated in domestic currency is far from rare, also in countries where policymakers are in principle in control of the printing press…The evidence stresses the importance of identifying the conditions under which a central bank can be effective in stemming disruptive speculation in the sovereign debt market.”

“How far is the government willing to raise taxes before exercising (optimally) the option to default? The fiscal capacity of the government is naturally defined as the maximum primary surplus that the country will …find it optimal to generate to …finance its interest bill in full…. Ultimately, the fiscal capacity is a function of the budget cost of default and the level of debt…. Under rational expectations, agents anticipate the optimal discretionary plan of the government conditional on the market interest rate…This condition, together with the conditionally optimal tax rate, the condition for choosing default, and the government budget constraint define an equilibrium.”

“Depending on the relative weight of the costs of default and taxation, and the level of debt, different equilibrium outcomes are possible… [There] is a non-fundamental equilibrium in which market participants coordinate their expectations on default… The self-fulfilling crises…emerge as a possibility only for a relatively high stock of government liabilities in relation to the fixed costs of default.”

When the government lacks credibility, the ability to generate seigniorage revenue [interest earned on securities in exchange for non-interest bearing central bank money] and debase debt with inflation…cannot prevent self-fulfilling debt crises. The reason is straightforward: inflation is not costless. There are trade-offs between default, taxation and inflation that bound the degree to which the central bank is willing to ex-post inflate public debt away in response to financial distress. Moreover, the moment investors anticipate inflationary …financing, interest rates would rise, reducing the gains from debt monetization, up to the point of undermining its effectiveness altogether.”

“Modern central banks in advanced economies issue liabilities (high powered money, not only in the form of cash but especially bank reserves, often interest-bearing) which are used both as means of payments and store of value. In our analysis, here is where the ‘printing press argument comes into play: independent central banks stand ready to honour their own liabilities, by redeeming them for cash at their nominal value. Hence, nominal liabilities issued by central banks are exposed to the risk of inflation, but not undermined by fears of [outright] default. By intervening in the sovereign debt market, then, central banks can effectively swap default-risky debt with default-free liabilities, lowering the borrowing costs for the public sector as a whole. This explains why monetary interventions can be successful, even if, from an aggregate perspective, any purchase of government debt by the monetary authorities is at best backed by their consolidated budget with the …fiscal authorities — i.e., there are no additional resources to complement tax and seigniorage revenues.”

“According to the most popular view, shaped after the conventional wisdom on the lender of last resort, the monetary authorities should stand ready to satisfy the government …financing needs at a preannounced rate in full. De-facto, the central bank should be willing to step in and fully replace private lending to the government, relying on an off-equilibrium threat to coordinate market expectations on the fundamental equilibrium… But to be successful, the prospective interventions of the central bank must be credible, that is, they must be both feasible and desirable from the point of view of the monetary authorities. We show that a way to ensure credibility is cooperation between the fiscal and monetary authorities, acting under a consolidated budget constraint.”

“Indeed, the credibility of large-scale interventions is easily at stake (hence they may not be effective), if cooperation is constrained by the requirement that the central bank breaks even in all circumstances — i.e., it is held responsible for servicing its liabilities in full, without relying on …fiscal transfers…On the one hand, it is often the case that institutional arrangements or political constraints rule out or limit fiscal transfers to monetary authorities. On the other hand, central banks are typically wary of asking for fiscal support to guard their independence.”

“Under institutional constraints preventing full budget consolidation across monetary and fiscal authorities…the required scale for interventions to be effective strikes a balance between two competing forces. Debt purchases must be large enough to reduce market holdings of debt to a level that makes default suboptimal relative to its economic costs; they must be low enough that possible losses due to default under adverse fundamental circumstances can be entirely covered by the (present discounted value of) seigniorage.”



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