For macroeconomists. Paul Krugman needed more coffee to get his head round the latest paper by Corsetti and Dedola. I had a similar feeling, and I have written this post to try and get my thoughts in order. So this comes with a health warning, which is that I may have failed.
This post is all about the distinction between central banks and governments, but to make those distinctions clear, its helpful to consolidate their budget constraints. Initially assume that this consolidated entity can finance its deficit by either issuing bonds or printing cash. It is therefore true that this entity need never default: if no one buys its bonds, it just issues cash. However that does not mean that it will never default. Suppose, as Corsetti and Dedola do, there is a direct and simple link between cash and inflation, while issuing debt has no impact on inflation. Avoiding default by printing cash therefore creates inflation, which is costly. It may be so costly that the government/central bank entity chooses to default, rather than bear those costs.
I do not think this idea is controversial, but failure to distinguish between ‘need’ and ‘choose’ can cause confusion. What may be controversial in the above is the simple quantity theory link between cash and inflation, but in fact we do not need anything so sharp. As long as printing cash is more likely to raise inflation than issuing debt, the proposition still holds. What the exact nature of the inflation link will influence, of course, is the likelihood the government will choose to default rather than create higher inflation.
This choice may also be influenced by the existence of independent central banks. If governments give control over printing money and inflation to a conservative central banker in the Rogoff sense, then this could decrease the likelihood of using inflation to avoid default, and therefore makes default more likely for a given fiscal position. This may also, of course, influence fiscal policy. Whether independent central banks have that much independence is of course debatable.
Now let’s add the possibility of multiple equilibria. The ‘good’ equilibria is the one where the interest paid on government debt reflects the ‘true’ probability of default i.e. it reflects the circumstances in which the consolidated government chooses to default. The ‘bad’ equilibrium is one where the rate of interest reflects a much higher probability of default. As De Grauwe has recently emphasised, because the market can in effect force default by not buying debt, this bad equilibrium is possible.
However as our consolidated government/central bank can print cash, does this rule out the bad equilibrium? The answer, according to Corsetti and Dedola, is not necessarily. The reason is straightforward. Printing cash is still costly, because it raises inflation. The bad equilibrium could still exist, because to prevent it would require creating an undesirable amount of inflation, which the consolidated government will not at the end of the day do, whatever it may say it will do.
However Corsetti and Dedola note that in practice, central banks are buying government debt not by printing cash, but by creating reserves. So they extend their model to include a third asset, bank reserves. In terms of the consolidated government, what are these reserves? In Corsetti and Dedola I think reserves are default free debt. They pay a risk free interest rate, but there is no chance of default, because (by some means) the central bank always promises to pay back the interest and capital with money. However, like government debt and unlike money, there is no link between the quantity of reserves and inflation.
Now I find it intuitive that with this additional asset, it is now possible to remove the bad equilibrium, as the authors show. The government/central bank can simply choose to swap any normal debt that the market will not buy with reserves, which the market will buy, because reserves are default free. The government/central bank is essentially ruling out its option to default. Why does the government/central bank ever issue bonds? In the absence of the possibility of a bad equilibrium, it might prefer issuing bonds because it wants to keep the default option.
I have traditionally thought about Quantitative Easing as being equivalent to swapping debt for cash. For exactly the reasons Corsetti and Dedola outline in a world without reserves, to do this permanently would raise the price level, so as a result QE is strictly temporary. But now add reserves of the Corsetti and Dedola type. QE then involves a swap between two types of debt: one default free and one not. The consolidated government/central bank is reducing its option to default on debt, in order either to remove a bad equilibria, change the term structure, increase the supply of completely safe assets, reduce its interest bill, or something else.
Now what is crucial in this analysis is that issuing reserves, unlike issuing cash, has no implications for inflation. You might object that while that clearly seems realistic at the moment, this reflects the peculiar circumstances of the zero lower bound (ZLB), and in the longer term additional reserves would be inflationary because they would allow private banks to create more loans and deposits etc etc. However in this context a recent post from Paul De Grauwe and Yuemei Ji is interesting.
De Grauwe and Ji, among many other things, consider the situation in a which the central bank buys government debt with reserves, and the government defaults. It is then often suggested that the central bank loses the ability to control interest rates and inflation. De Grauwe and Ji argue that this “does not hold water” for two reasons: the central bank can reduce the money stock by either raising reserve requirements, or by issuing interest bearing bonds. So would a permanently higher stock of reserves necessarily imply higher inflation once the ZLB was over? Following De Grauwe and Ji the answer is no, because either private banks can be forced to hold more reserves and not create more deposits, or the central bank could exchange reserves for some other kind of central bank asset that was still default free but which had no knock on implications for the banking sector.
So to the extent that reserves are just default free debt, or can be turned into default free debt, QE does not need to be temporary even with unchanging inflation targets. Whether this is of any consequence I’m not sure, particularly as central banks do not want to make QE permanent, as recent events illustrate. Seeing reserves as default free debt may also not be terribly interesting for the UK or US right now as the perceived default risk of each country’s debt is pretty low anyway, and so the chances of a bad equilibrium emerging are equally low. But the implications for the Eurozone are clearly much more interesting.