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USMPF13 Final

USMPF13 Final

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Published by Gill Wallace Hope

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Published by: Gill Wallace Hope on Feb 25, 2013
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Crunch Time: Fiscal Crises and the Role of MonetaryPolicy*
 David GreenlawJames D. HamiltonPeter Hooper Frederic S. MishkinFebruary 22, 2013 ________________________________________________ 
EMBARGOED UNTIL 1015AM, EST, FEBRUARY 22. PLEASE DO NOTCITE OR CIRCULATE UNTIL AFTER THAT TIME AND DATE.
  ______________________________________________ 
This paper was written for the U.S. Monetary Policy Forum, New York City,February 22, 2013. We thank Anil Kashyap for helpful comments. We also thank Matthew Luzzetti, Rumki Majumdar, and John Abraham for their substantivecontributions to our analysis and Richard Cunniff for editorial assistance. The viewsexpressed here are ours alone and do not necessarily reflect those of the institutions withwhich we are affiliated. Author affiliations and email addresses: Greenlaw: ManagingDirector and Chief U.S. Fixed Income Economist, Morgan Stanley(David.Greenlaw@morganstanley.com); Hamilton: Professor of Economics, Universityof California at San Diego ( jhamilton@ucsd.edu
 
) and Research Associate of the NationalBureau of Economic Research; Hooper: Managing Director and Chief Economist,Deutsche Bank Securities Inc. ( peter.hooper@db.com); Mishkin: Alfred Lerner Professor of Banking and Financial Institutions, Graduate School of Business, Columbia University(fsm3@columbia.edu) and Research Associate of the National Bureau of EconomicResearch. Disclosure of Mishkin’s outside compensated activities can be found on hiswebsite athttp://www0.gsb.columbia.edu/faculty/fmishkin/ 
 
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ABSTRACT
 Countries with high debt loads are vulnerable to an adverse feedback loop inwhich doubts by lenders lead to higher sovereign interest rates which in turn make thedebt problems more severe. We analyze the recent experience of advanced economiesusing both econometric methods and case studies and conclude that countries with debtabove 80% of GDP and persistent current-account deficits are vulnerable to a rapid fiscaldeterioration as a result of these tipping-point dynamics. Such feedback is left out of current long-term U.S. budget projections and could make it much more difficult for theU.S. to maintain a sustainable budget course. A potential fiscal crunch also putsfundamental limits on what monetary policy is able to achieve. In simulations of theFederal Reserve’s balance sheet, we find that under our baseline assumptions, in 2017-18the Fed will be running sizable income losses on its portfolio net of operating and other expenses and therefore for a time will be unable to make remittances to the U.S.Treasury. Under alternative scenarios that allow for an emergence of fiscal concerns, theFed’s net losses would be more substantial.
 
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1 Introduction.
As recently as the 1990s, the United States government was running budgetsurpluses and there was serious discussion of what would happen if the federalgovernment was able to retire its debt. Although the fiscal situation deterioratedsomewhat in the United States after 2000, countries in Europe, especially Ireland andSpain, were able to reduce the level of their government debt relative to national incomeup until 2007. However, when the global financial crisis turned virulent in 2008,everything changed. The subsequent sharp economic downturn in advanced countriesreduced fiscal revenues and led to increased government spending, with the result thatgovernment debt has grown dramatically for most developed economies since 2008. Atthe same time, central banks have sought to stimulate their weak economies withunprecedented expansions of their balance sheets.The challenges for policy entered a new phase in 2010 when several Europeancountries suddenly faced rapid increases in borrowing rates on sovereign debt thatrendered their current fiscal policies unsustainable. But a fiscal contraction in thesecircumstances had the potential to make the economic situation even worse bycontracting aggregate spending, while further monetary accommodation could lead to atipping point in inflation and currency flight. Given the suddenness with which these problems have become manifest, it is critical to understand the circumstances that giverise to tipping points in sovereign debt markets and examine the implications for monetary policy.We start our analysis in Section 2 by sketching a simple model of debt dynamicsto explore the relationship between sovereign debt loads and interest rates. Based on the

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