“Whatever It Takes” Is All You Need: Monetary Policy and Debt Fragility

Abstract

The valuation of government debt is subject to strategic uncertainty. Pessimistic lenders, fearing default, bid down the price of debt, leaving a government with a higher debt burden. This increases the likelihood of default, thus confirming the pessimism of lenders. Can monetary interventions mitigate debt fragility? With one-period commitment to a state-contingent policy, the monetary authority can indeed overcome strategic uncertainty. Under discretion, debt fragility remains unless reputation effects are sufficiently strong. Simpler forms of interventions, such as an inflation target, cannot eliminate debt fragility. (JEL E31, E43, E52, E62, G01, H63)

Sovereign Debt Sustainability and Central Bank Credibility

“…In Calvo's (1988) model, it could cap the sovereign's cost of borrowing below 𝑅 𝑏 , so that the government would never be tempted to default, ruling out the "bad" equilibrium. This insight carries over to Lorenzoni and Werning (2019: 3250) and is also the focus of recent papers by Corsetti and Dedola (2016) and Camous and Cooper (2019). Another channel through which a central bank can reduce rollover risks is through asset purchase programs ("quantitative easing") that swap privately-held bonds of finite maturity for central bank reserves which do not need to be rolled over.…”

“…• First, the central bank must be credible in the sense that it has control over the inflation rate and at least some control over real interest rates (see in particular Camous and Cooper 2019). If a central bank bailout of the government is expected to lead to high inflation, it could not rescue a sovereign from a Sachs (1984)-style rollover crisis, because investors would not want to hold newly issued debt whose value is expected to be eroded by high inflation (Cagan, 1956).…”

Monetary Finance

“…These mechanics have been analyzed in Aguiar and others (2013) and Camous and Cooper (2019) using models of self-fulfilling sovereign debt crises. If markets lose confidence in debt sustainability and the central bank does not intervene, the country can only either fully repay the maturing debt through fiscal consolidation or default.…”

“…The reduction in sovereign spreads following the ECB's pledge to halt the crisis (President Draghi's "whatever it takes" speech)-standing ready to purchase distressed sovereign bonds-supported the notion that central banks can provide an effective liquidity backstop against self-fulfilling runs. These insights have been examined in recent academic research (Aguiar and others 2013;Corsetti and Dedola 2016;Bacchetta, Perazzi, and Van Wincoop 2018;Camous and Cooper 2019).…”

The Central Bank Strikes Back! Credibility of Monetary Policy under Fiscal Influence

“…Also, the game-theoretic implications of strategic monetary rules are similar to , Atkeson, Chari and Kehoe (2010), or Camous and Cooper (2019), where off-equilibrium policies influence equilibrium outcomes. These studies develop this idea in environments plagued by multiple equilibria with the objective to implement a unique and superior equilibrium outcome.…”