Central Bank Policies and the Debt Trap.

• Author: Orphanides, Athanasios

Monetary theory is like a Japanese garden. It has esthetic unity born of variety; an apparent simplicity that conceals a sophisticated reality; a surface view that dissolves in ever deeper perspective. Both can be fully appreciated only if examined from many different angles, only if studied leisurely but in depth.

--Milton Friedman (1969)

The combination of high government debt levels and the unprecedented monetary expansion implemented by central banks around the world since the 2008 financial crisis has raised concerns about the potential for money mischief. Whenever a government faces the prospect of a high debt trap, money printing can be a tempting way out. Relying on inflation to eat away the real value of the debt may be far more appealing politically than raising more taxes to repay it. Since 2008, through quantitative easing policies, central banks in many large economies have been effectively printing money and purchasing government debt with the proceeds. Should we worry? While the risk of debt monetization can never be completely dismissed in a monetary economy, a rapid increase in high-powered money is not necessarily a harbinger of inflation. As suggested in the epigraph, taken from the Preface of Milton Friedman's The Optimum Quantity of Money, in monetary phenomena surface appearances may be misleading and require deeper analysis from multiple perspectives to appreciate fully. (1)

This article delves into an international comparison of central bank policies in relation to government debt dynamics since the crisis. It examines the policies of the Federal Reserve, Bank of Japan (BOJ), and European Central Bank (ECB) and their respective effects on the United States, Japan, Germany, and Italy. Monetary policy and fiscal dynamics are inexorably linked but not only through the potential for debt monetization. Within limits, central banks can allay market concerns about fiscal dynamics without compromising price stability. This can be achieved through policies that promote economic growth, which are crucial when aggregate demand is depressed as was the case in the aftermath of the crisis. It may also be achieved through financial repression, which reduces the real cost of refinancing government debt. (2) Financial repression is a feature of quantitative easing (QE), and, although it is associated with distortions, it nonetheless deserves attention because it may be preferable to alternative policies with potentially higher economic costs, such as debt monetization through high inflation or debt default.

In the aftermath of the crisis, a crucial challenge faced by the Fed, the BOJ, and the ECB was to provide sufficient accommodation to the economy while facing the zero lower bound (ZLB) on interest rates that constrained conventional monetary policy. All three central banks provided additional accommodation by expanding their balance sheets and engaging in some form of QE. Despite rapid increases in high-powered money, inflation has remained subdued. Indeed, for all three central banks, inflation has been below their respective goals, on average, since the crisis. Moreover, because financial repression is a feature of QE policies, balance-sheet expansions also helped improve debt dynamics. However, the effectiveness of these policies varied, as can be seen by comparing Japan and Italy. Whereas BOJ policies have successfully allayed concerns about Japanese government debt dynamics without compromising price stability, ECB policies, which apply to all members of the eurozone, appear to have favored Germany at the expense of Italy, with adverse consequences on market concerns regarding the sustainability of Italian government debt.

With regard to the normalization of the extraordinary accommodative policies adopted since the crisis, the Fed's current experience is compared with that of the QE policies in the 1930s. The historical precedent suggests that policy normalization could be achieved over time without shrinking the Fed's balance sheet. Maintaining the current size of the balance sheet, while nominal GDP grows in line with the economy's potential output growth and 2 percent inflation, would lead to a reduction of the Fed's balance sheet as a percentage of GDP similar to that recorded after the 1930s balance-sheet expansion. If the current size of the balance sheet is maintained, however, a faster pace of increases in short-term interest rates would be required to preserve price stability.

Debt Dynamics and the Debt Trap

To organize the discussion, it is instructive to review some basics of debt dynamics and factors that can contribute to or allay concerns of a government being caught in a debt trap. Equation 1 provides a useful summary of the evolution of debt dynamics for a government that finances shortfalls in its expenditures over revenues (the primary deficit) through the issuance of nominal bonds in local currency: (3)

(1) [DELTA]b = (r - g) [b.sub.-1] + d

The equation shows how the change of the debt-to-GDP ratio from one period to the next, [DELTA]b, depends on the previous period's debt-to-GDP ratio, [b.sub.-1], the primary-deficit-to-GDP ratio, d, the real interest rate, r, and the real growth rate, g.

A government faces the prospect of being caught in a debt trap if the debt-to-GDP ratio is persistently rising over time, risking reaching levels so high as to question the government's ability to refinance it. Eventually, this raises prospects of defaulting on the debt. High primary deficits for a time (high d) can elevate the debt-to-GDP ratio, b. Indeed, persistent primary deficits are invariably the root cause of debt problems. However, a more critical factor for debt sustainability is whether the cost of refinancing the debt is expected to be persistently higher or lower than the growth of the economy. To see this consider the case when a state with a positive debt level runs a primary balance, d = 0. For this state, government finances will still be in deficit with the total deficit being equal to the interest cost of servicing the existing debt. The total level of debt will be rising over time. But if GDP is rising even faster, the debt-to-GDP ratio will be declining, nonetheless. The key is how r compares with g. If the interest rate on the debt is lower than the growth of the economy, r < g> then the debt-to-GDP ratio will be declining over time. Conversely, if r > g > the debt-to-GDP ratio will be rising over time, rendering the debt unsustainable.

What can push an economy to the debt trap? First, policies that kill growth. Persistent periods of low or negative growth can create debt problems even if a government is not maintaining primary deficits. Second, for any given level of nominal interest rates, policies that deliver too low inflation or deflation. By raising the real interest rate a government faces to refinance its debt, deflation can render debt dynamics unsustainable. Third, for any given level of risk-free real interest rates, policies that raise the perceived risk characteristics and thus the cost of refinancing the debt. For example, policies that induce fear that a government might be forced to default on its debt obligations in the future raise the risk premium investors demand as compensation for such fears. Such policies therefore raise the real interest rate a government faces to refinance its debt and can render the debt unsustainable. This channel also illustrates how fears of default can be self-fulfilling, reflecting situations where default fears render a given level of debt unsustainable when in their absence debt would be sustainable.

How to avoid a debt trap? First and foremost with sound fiscal policy. Avoiding persistent primary deficits in the first place eradicates high debt levels and maintains the fiscal space needed to pursue countercyclical fiscal expansions in recessions without raising concerns of debt sustainability. Second, by promoting higher real growth over time. Structural policies that raise potential output growth can have particularly high payoffs in the long run, though they may be unpopular and difficult to implement for political reasons.

Central bank policies also have important implications for debt dynamics. Some policies can unnecessarily worsen debt dynamics. In a recessionary environment (e.g., as experienced in the global economy in the aftermath of the financial crisis) monetary policy that is insufficiently accommodative can induce persistently low inflation, lower than a central bank's definition of price stability, and depress growth. Inappropriately tight monetary policy can create a debt problem for a government even if primary deficits are kept low.

Central banks can also diffuse debt concerns but with potentially undesirable consequences. A classic example of money mischief is debt monetization. Money printing can diffuse an unsustainable debt situation by repaying the nominal value of the debt with freshly printed and increasingly worthless money. High inflation effectively wipes out the real value of existing debt. But it also destabilizes the economy, harming growth over time.

There is, however, another central bank policy option that can reduce, within limits, the risks associated with high debt without compromising price stability: financial repression. The central bank, sometimes in coordinated actions with the government, can induce conditions that reduce...