20 June 2015

VoxEU: Can central banks avoid sovereign debt crises?

Self-fulfilling sentiments and sovereign debt

A popular explanation for the sovereign debt crisis that has impacted European periphery countries since 2010 is self-fulfilling sentiments. If market participants believe that sovereign default of a country is more likely, they demand higher spreads, which over time raises the debt level and thus makes eventual default more likely. This view of self-fulfilling beliefs is consistent with the evidence that the surge in sovereign bond spreads in Europe during 2010-2011 was disconnected from debt ratios and other macroeconomic fundamentals (e.g., de Grauwe and Ji 2013). However, countries with comparable debt and deficits outside the Eurozone (e.g., the US, Japan or the UK) were not impacted. This difference in experience has often been attributed to the fact that the highly indebted non-eurozone countries have their own currency (see, for example, Krugman 2013). A central bank has additional tools which can avoid self-fulfilling debt crises. In fact, the decline in European spreads since mid-2012 is widely attributed to a change in ECB policy towards explicit backing of periphery government debt.

While it is certainly possible for a central bank to adopt a policy that avoids a self-fulfilling default equilibrium, such a policy needs to be credible. If it is credible, it would not even be necessary to actually implement the policy. The bad equilibrium is avoided altogether. A central bank could always surprise debt holders by creating inflation or could buy large amounts of government debt by printing money. But how high should inflation be? And how easy is to create surprise inflation when prices are rigid? If the required inflation is too high, investors will not believe in such a commitment and the ‘bad’ equilibrium could not be avoided. In the end, this is a quantitative question that requires a reasonably realistic model. 

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Concluding remarks

Given these results, one might wonder why Draghi’s ‘whathever it takes’ announcement in 2012 has been effective in reducing spreads. Our perspective is that the ECB can easily replace safer core countries’ government debt with risky periphery government debt with no implications for monetary policy. This is possible because the stock of existing central bank assets is large compared to the level of risky government debt. This is however a case that is special to the periphery of a monetary union. The ECB would be powerless if there were a broad sovereign debt crisis across the eurozone, in the same way that the Fed or Bank of Japan would be powerless to credibly avoid a self-fulfilling debt crisis in their countries.

Overall, our conclusion is that the ability of the central bank to avert a debt self-fulfilling debt crisis is limited. While in theory there are policies that could make the public debt level sustainable, our quantitative analysis shows that central banks usually cannot credibly commit to such policies.

Full article on Vox EU (with charts)

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