On Voxeu, there lately has been a string of interesting exchanges on macro policy issues and trends. A first series last month tackled the lessons on the financial crisis and how to deal with it, amongst which some interesting angles on sovereign debt crisis and austerity. Early this week however, an interesting paper appeared from professors Corsetti (Cambridge) and Dedola (ECB), not coincidentally from Italian origin concerning their subject.
Their starting point is : Spain and the UK have similar debt problems. Yet Spain faces far higher sovereign interest rate charges, why ? Is this because Eurozone (EZ) membership makes national economies vulnerable to selfulfilling debt crises ?…… Market analysts and policy makers have recently put forth the point of view that the EZ is basically issuing sovereign debt in “foreign currency”, foreign in the sense that national authorities within the EZ don’t control the printing press.
Ever since last year, I have been pondering on this as well and time after time people come forward with this argument : The UK, the US, Japan, or basically every one engaging in some kind of QE with great determination, enjoys the benefit of market doubt because they have their “own” currency and capabilities to monetize debt, if necessary @ infinitum.
Now I find this logic also a bit twisted to say the least. In addition, if QE has big effects on liquidity and expanding the money supply, it should create inflationary forces in the end – or at least raise market expectations on inflation. Nevertheless, advocates claim that this should not trigger vicious circle mechanisms such as default fears – higher rates – debt ratios spiraling out of control – higher rates and so on and hence default being realized in the endgame. The black box of the printing press apparently solves this issue.
However, if the unlimited use of the printing press is to inflate debt away as a way forward, well, inflation in the end comes at a cost. And it is not a necessary remedy to control the debt ratio (interest rates and expectations do play a role in this game, also from a purely mathematical point of view).
In addition and without having to refer to Rogoff & Reinhart, history is a cemetery of nations going into default, even if they dispose of a national printing press and issuing debt in “domestic” currency.
The points the authors refer to as being important and worthwhile further following up are :
What can trigger the so-called “crossing the Rubicon effect”. By this, they mean what are triggers for setting a vicious circle into motion towards default without being capable of reversing the trend ; Or, once Ceasar crossed the river, the dices were thrown and there was no way going back, irreversible.
And in a first series of papers, Olivier Blanchard (currently IMF) makes an interesting point about the content and the dose of austerity being implemented. If for example austerity takes on large proportions, financial markets might push rates even higher by dumping the paper. Why ? Well, if the fiscal multipliers are sufficiently big to have a large impact on grrowth (both on taxes as on expenditure), recessions persist or even deepen and the debt/GDP ratio doesn’t improve. So the default threat doesn’t go away.
Of course, the fact that these multipliers in itself can be so big says something about the structure of an economy and the impact of the state on its GDP. But that said, it’s an important element maybe to explain why Greece could be dead meat and why Japan is next on the barbecue. Even without taking austerity into consideration (o…