Is a currency crisis bad for you at the ZLB?

My and Paul Krugman’s comments on Ken Rogoff’s FT piece have generated an interesting discussion, including another piece from Ken Rogoff, a further response from Paul Krugman, and posts from Brad DeLong, Ryan Avent in the Economist, Matthew Klein, John McHale (follow-up here), Nick Rowe and Tony Yates. The discussion centred on the UK, but it is more general than that: a similar thought experiment is if China sells its US government debt. Paul Krugman has promised more, so this may be the equivalent of one of those annoying people in a seminar audience who try and predict with questions what the speaker will say.  

The track I want to pursue starts from my argument that Quantitative Easing (QE) will ensure that the UK government never runs out of money with which to pay the bills. The obvious response, which Paul Krugman’s comment took up, is that a market reaction against UK government debt might be accompanied by a reaction against the UK’s currency, leading to a ‘sterling crisis’. For those with a long memory of UK macro history, would this be 1976 all over again?

Ken Rogoff’s original article, and his reply, both focus on the trigger for these events being a collapse in the Euro. While such risks should be taken seriously (although, for the record, I have never thought such a break up was the likely outcome), I want to ignore this possibility here, simply because it introduces too many complicating issues. Instead I just want to look at a much more limited scenario. Specifically, suppose Labour had not lost the election, and austerity had been delayed (by more than Ken Rogoff would have thought wise, bearing in mind that he agrees that government ‘investment’ in its widest sense was in fact cut too aggressively). Suppose further that markets had decided that because of this alone it was no longer wise to buy UK debt. QE fills the gap, but the flight from UK debt is also a flight from sterling, which depreciates as a result. If the market believes the government is not solvent, it will assume some part of QE is permanent rather than temporary, so inflation expectations rise. This validates the fall in sterling, in the sense that the market does not see any capital gains to be made from its depreciation.

In this thought experiment the UK government is solvent before the crisis, so other things being equal QE will be temporary. We are not talking about a strategy of inflating away the debt. There are two directions we could follow at this point. One would be the idea that a depreciation makes the UK government insolvent: in other words the crisis is self-fulfilling. The analogy is with a funding crisis under a fixed exchange rate, where by pushing up the interest rate on debt, markets can induce the insolvency they fear. (The government was not insolvent under pre-crisis interest rates, but is insolvent if it has to borrow at post-crisis rates.) But its not clear how this would work when exchange rates are flexible. The depreciation would do nothing to raise current or future borrowing costs, or reduce the long term tax base. At some stage markets would realise their mistake. I cannot see why there are multiple equilibria here, but maybe that is a failure of my imagination.

The second direction is to focus on the short run costs of the nominal depreciation. Some of those who commented on my original post talked about a ‘downward spiral’ in sterling. Now of course the depreciation itself may raise inflation to some extent, but this is not an unstable process. At some point sterling falls to a point where the market now thinks it is OK to hold. There is no bottomless pit.

As domestic prices are sticky, the depreciation increases UK competitiveness, which increases the demand for UK goods. If the Zero Lower Bound (ZLB) is a constraint, then this increase in demand reduces or eliminates the constraint. It may also raise inflation because demand is higher, but higher demand is what monetary policy wanted but was unable to achieve. If the depreciation is so large that demand has to be reduced through increasing interest rates, that is fine: this is what monetary policy is for. In essence the ZLB is a welfare reducing constraint that the crisis relieves, and we are all better off.

If that sounds too good to be true, I think it could be. It treats the depreciation as simply a positive demand shock, that first eliminates the cost of the ZLB, and then can be offset by monetary policy. However a sterling crisis may also involve a deterioration in the output/inflation trade-off: equivalent to what macroeconomists call a cost-push shock. Take a basic Phillips curve. If agents start to believe inflation will be higher - even if these beliefs are incorrect (the crisis, and QE, is temporary) - while these mistaken expectations last this is a cost to the economy, because the central bank will have to raise interest rates to prevent these expectations fully feeding through into actual inflation. Either output will be lower, or inflation higher, or both.

Now as long as interest rates stay at zero, this is not a problem: the ZLB constraint still dominates. [1] However if the crisis was big enough, we could overshoot Brad DeLong’s sweet spot, and end up living with a cost-push shock that was more costly than the ZLB constraint. Personally I think this is stretching non-linearities rather too much. First you have to believe that austerity, which reduces debt a bit more quickly than otherwise, is just enough to prevent a crisis, and then that the crisis is so big that it more than offsets the ZLB constraint. Unlikely, but it seems to be a coherent possibility.

But what about 1976, when pressure on sterling led the UK government to seek help from the IMF? Of course that was different, because we were not at the ZLB. I also suspect there were other differences. I was a very junior economist working in the Treasury at the time. I do not remember very much, but what I do remember was that there seemed to be a mindset among senior policy makers that sterling was on a kind of slippery slope. Once it started falling, who knows where it might end up? They seemed to believe there was a bottomless pit, and the IMF loan was required to stop us going there. I suspect that was in part just a lack of familiarity with how flexible exchange rates work. In the end, sterling did stabilise such that some of the IMF loan was not needed, and I wonder how necessary it really was. But if anyone who reads this post knows more about this period, I would be very interested in their thoughts.

[1] A possibility suggested by John McHale is that, although the interest rate set by the Bank of England could stay at its lower bound, there might be an increase in the interest rate spread, such that UK firms or consumers end up paying more. I’m not clear in my own mind why a depreciation would raise this spread. Even if the market believes the UK government is no longer solvent, the central bank still has the ability to prevent a run on UK banks. If the spread did increase, then programmes like Funding For Lending would still be possible.