Interest Rate Targets and Speculative Attacks on Public Debt

Abstract

The application of exchange rate target zones modeling to interest rates allows interpreting the puzzles that emerged with the public debt euro area crisis, namely the nonlinear behavior of the interest rates and the fact that some stand-alone countries, not belonging to the euro area, have not been subject to speculative attacks in spite of equally large public debt-to-gross domestic product (GDP) ratios. As a matter of fact, this model shows that in the case of a noncredible upper threshold for the interest rate (that may be due to both the lack of room for increasing further the required government primary surplus and/or the absence of a monetary authority acting as a lender of last resort), the resulting public debt unsustainability determines an interest rate nonlinearity and makes the crisis possible for public debt levels that would be stable in the presence of a credible interest rate target.

Optimal public debt composition during debt crises: A review of theoretical literature

“…First, the non‐tradability of bank loans protects a country facing a crisis from speculative attacks that exacerbate the debt crisis. In the case of tradable securities, the collective action of speculators to immediately sell securities (to raise the yield and lower the price of securities) will induce other investors to follow, thereby increasing the debt servicing costs and rendering public debt more unsustainable (Della Posta, 2019). Second, during a crisis, bank loans are not affected by the deteriorating sovereign credit rating—unlike tradable securities—and this can make bank loans cheaper, contrary to Tanaka's (2006) argument.…”

Central bank intervention, public debt and interest rate target zones

“…The celebrated 'honeymoon' model of exchange rate TZs, presented by Paul Krugman at the end of the 1980s and published eventually in 1991 (Krugman, 1991), generated a vast amount of literature. 2 A summary of the main conclusions obtained in that literature is contained in Della Posta (2017), who applies the approach followed by Krugman (1991) and Bertola and Caballero (1992) to the euro area crisis. In doing so he refers also to Tamborini (2015), who shows how the credibility of the fiscal consolidation required in order to stabilize public debt may be questioned by the feasibility of the primary surplus that a government can run.…”

“…The role of potential liquidity has remained hidden in the background so far, and did not play any role in Della Posta (2017).…”

“…Della Posta (2017) uses the exchange rates target zones (TZs) modeling technique and applies it to a case of interest rate targets. He shows that when the interest rate is expected to exceed the target assuring public debt stability, speculation is encouraged.…”

The economic and social costs of globalisation: A target zone analysis

“…5 A summary of the main conclusions obtained in this literature-initially dedicated to the stabilising or destabilising effects of the imposition of a target zone on exchange rates-is contained in Della Posta (2018b), which applies this approach to study the speculative attacks on public debt that characterised the euro area crisis over the years 2011-12. Della Posta (2019) argues that the expectation of an upper threshold limiting the social viability of the primary budget surplus works exactly like the upper end of an exchange rate target zone regime.…”