This is from an Interview with Gita Gopinath conducted by Douglas Clement (many other topics are covered as well):
Interview with Gita Gopinath:... Monetary unions and sovereign debt
Region: You’ve done quite a lot of other work on monetary unions, much of it with Aguiar, Amador and Farhi. In “Coordination and Crisis in Monetary Union,” you examine the incentives that high-debt nations face when joining a monetary union. Standard theory suggests that the low-inflation credibility of an austere monetary union might be optimal for high-debt countries, since the union’s low inflation won’t tempt high-debt nations to borrow more in the hope that debts will be inflated away.
But your research suggests otherwise. You find that in some cases, high-debt nations would want a mix of nations, some with similar high-debt profiles as well as some low-debt nations.
Could you explain that result? Why would a nation like Greece benefit from being with other high-debt countries like Italy, as well as low-debt countries like Germany?
Gopinath: The way to understand the result is to recognize that while there are some debt crises that are based on fundamentals—such as when the government spends excessively relative to output, or output growth collapses—there are others that arise from market failures like coordination failures among lenders. In the case of coordination failures, debt crises arise when panicking investors refuse to roll over debt at low enough interest rates; that panicked response pushes a country into default.
The classical argument applied to a world where such crises did not arise. As all crises were assumed to be driven by bad decisions of governments, the argument went that a country like Greece with high debt should be in a union with Germany because that made it able to credibly commit not to inflate away its debt. Greece would also want to be in such a union with Germany because then it could borrow at lower interest rates.
But what if it’s not just about the problems created by the government, but you also have problems created by the markets: financial contagion or self-fulfilling crises, coordination failures among investors, problems along those lines? What happens in that world? Well, in that world, you actually want a central bank who is able to credibly say that it will intervene in the events of markets going haywire to prevent the price of your bonds from collapsing, to prevent a crisis from occurring. This credibility arises when the union has a sufficient number of high-debt members.
Region: Mario Draghi provided that kind of reassurance in his July 2012 London speech, no?
Gopinath: Exactly! “Draghi’s put,” which we can always interpret in many different ways, but his strong suggestion was that the European Central Bank would intervene to buy sovereign debt and prevent its prices from collapsing.
Region: It was simply the promise of “whatever it takes.”
Gopinath: Simply the promise.
Region: Regardless of its actual policy implementation, and it never was—it was rendered unnecessary because it calmed markets.
Gopinath: Exactly, and those are the situations where you actually know it’s a panic-driven crisis. If it were a fundamentals-driven crisis, then if the ECB said, “OK, we’re going to bail out these guys,” and the fundamentals were actually bad, then they would have needed a bailout.
But if it is driven by market panic, then just reassuring markets kills the panic and prevents a debt crisis.
Another reason it is important is that when they were having discussions way back in the beginning about monetary union, they spent a lot of time talking about what happens if we bring Germany and Greece together and they have very different growth rates and inflation rates. If we have just one instrument, just one interest rate for both those countries, that can be a problem. That was one of the standard concerns.
What they spent a lot less time thinking about is, what if you bring countries with different levels of debt together? Who’s going to play the lender of last resort?
Region: But the Stability and Growth Pact addressed that to some degree, didn’t it? And your research provides support for the debt ceiling set in the pact.
Gopinath: The Stability and Growth Pact does not help to deal with self-fulfilling debt crises. What it does help with is addressing excessive debt accumulation in the union. An individual country in the union may think, “I’m a small part of the whole union, so if I on the margin raised my debt by a little bit, I’m not going to have much of an effect on the central bank’s temptation to inflate.” But if every country does that, you will end up having an effect on inflation. That’s the fiscal externality, and that’s why you would need a Stability and Growth Pact.
The fact that it was forbidden for the European Central Bank to be the lender of last resort was, in the original rules of the game for the ECB, meant to prevent moral hazard problems of countries borrowing excessively. I think it’s a perfectly good argument, but you have to recognize that there will be times when it’s not about a government behaving badly, but about market panic.
Our paper was basically arguing that—while not ignoring issues in the debt market—monetary policy has a legitimate role to play. After the Draghi put, the ECB was taken to court as it was argued that this was not part of the original [EMU] agreement. This is a very reasonable question for people to ask: Is there a role for monetary authorities in debt crises? And I think our paper basically says yes. You certainly do not want to be the central bank that always bails out governments in trouble, but it absolutely has to give itself the possibility of doing it—once in a while. ...