It’s not just the currency

Paul Krugman writing in June 2012 on the UK-Spain interest differential, attributing it to the constraints of currency union -

Then there’s the lender of last resort issue, which turns out to be broader than even those who knew their Bagehot realized. Credit for focusing on this issue goes to Paul DeGrauwe, who pointed out that national central banks are potentially crucial lenders of last resort to governments as well as private financial institutions. The British government basically can’t face a “rollover” crisis in which bond buyers refuse to purchase its debt, because the Bank of England can always step in as financier of last resort. The government of Spain, however, can face such a crisis – and there is always the risk that fears of such a crisis, leading to default, could become a self-fulfilling prophecy. As DeGrauwe has pointed out, Britain’s fiscal outlook does not look notably better than Spain’s. Yet the interest rate on British 10-year bonds was 1.7% at the time of writing, whereas the rate on Spanish 10-years was 6.6%; presumably this liquidity risk was playing an important role in the difference.

At the Jackson Hole Federal Reserve Bank of Kansas City central bankers symposium yesterday, one of the more interesting papers, by Faust and Leeper –

Why, if Spanish debt was in safe territory, did its 10-year bond yields begin to rise in 2011? Figure 14 suggests that more than bond-market vigilantism was in play. During the decade of good fiscal housekeeping, Spanish inflation was chronically above union-wide inflation, at times by more than a percentage point. Thoughtful observers would note that in a monetary union, Spain’s persistently higher-than-union-wide inflation rates could damage the country’s competitiveness and future growth prospects. With weak future economic growth come lower tax revenues and higher social safety-net expenditures that reduce the expected flow of Spanish primary surpluses and shift the country’s fiscal limit in toward prevailing and growing debt levels. Whether from lack of competitiveness or some other source, Spain did experience a second dip in economic growth from 2011 through the middle of 2013. Unemployment continued the upward march that it began during the recession, rising well above 20 percent before peaking at 27 percent in February 2013. These developments raised concerns about Spain’s ability to finance government debt that rose from 69 to 92 percent of GDP between 2011 and 2013. Movement of debt toward Spain’s fiscal limit coincided with an inward shift in the country’s limit distribution, a combination that Bi’s (2012) fiscal limit analysis predicts would raise risk premia.
Fiscal limits tell us that debt-GDP ratios are an incomplete—and potentially misleading— summary of a country’s fiscal health. What matters is the distance between current debt and the fiscal limit distribution. The position and shape of that distribution, in turn, depend on the great many factors that determine the discounted value of future primary surpluses. As the Spanish and U.S. fiscal stress examples illustrate, interactions between cyclical outcomes (inflation and unemployment) and longer-run developments (fiscal financing and sustainability) run in both directions to compound the confounding dynamics.

Bottom line: the interest differential that seemingly favoured the UK over Spain is about more than the Bank of England’s ability to finance the government in a crisis. It’s also about the other factors which determine the likelihood of such a crisis in the first place.

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