Monetary Policy Issues when
Public Debts are Large
Stefan Gerlach
CEPR
CEPR-RIETI Workshop on “Fiscal Sustainability”
Tokyo, December 10, 2015
1
Motivation
 Sustainable public finances are of crucial
importance for monetary policy.
 In recent years, several euro area members have
experienced severe fiscal difficulties.
 Some small economies required a bail out.
 Some large economies were stressed.
 Many believed that these were country-specific
events of little importance to the euro area.
 But spill overs over sovereign risk appear to have been
much larger than expected.
 Cross-country holdings of debts and counterparty risk
provides transmission mechanism.
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Motivation (2)
 Focus on what has been learned about the
monetary policy implications of large public
debts.
 Outline:
 Review debt/deficit developments.
 Discuss how public debts constrain monetary policy.
3
Public Debt, 2005-2015
Global
Public Debt (to nominal GDP)
Euro Area
Germany
Spain
Euro area
Italy
Ireland
Greece
5.5
5.5
5
5
4.5
4.5
4
4
3.5
3.5
3
3
Euro area
United States
United Kingdom
Total OECD
Japan
Source: OECD Economic Outlook
4
Fiscal Deficit, 2005-2015
Euro Area
35
30
25
20
15
10
5
0
-5
Government financial balance (ratio to
nominal GDP)
Government financial balance (ratio to
nominal GDP)
Global
35
30
25
20
15
10
5
0
-5
Germany
Euro area
Ireland
Euro area
Total OECD
Italy
Greece
Spain
United Kingdom
United States
Source: OECD Economic Outlook
Japan
5
Long-term interest rates, 2005-2015
Global
per cent, per annum
Euro Area
Germany
Ireland
Euro area
Spain
Italy
Greece
25.0
25.0
20.0
20.0
15.0
15.0
10.0
10.0
5.0
5.0
0.0
0.0
Japan
Euro area
United Kingdom
United States
Source: OECD Economic Outlook
6
Policy concerns




Debt and inflation.
Distraction for monetary policy.
Debts and fiscal policy.
Debts and the monetary transmission
mechanism.
 Price channel
 Liquidity channel
 Balance sheet channel
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Debts and inflation
 A common concern is that large public debts
are seen as invitations for inflation.
 Hyperinflations in Germany and elsewhere in 1920s.
 But not in a number of other countries.
 Combination of large debts, unstable politics and lack of
central bank independence.
 Not a current concern in euro area.




Prohibition on monetary financing.
Difficult to raise inflation quickly.
Market participants alert.
Relatively short maturity structure of debt.
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Debts as a distraction for monetary policy
 Policy makers may worry about unstable debt
dynamics.
 Raising interest rates aggravates debt problems:
 Slows the economy, raising deficits and debt/GDP ratio.
 Increases debt-servicing costs.
 Risk that central banks hesitate to raise rates when
needed.
 Not an issue in euro area.
 Debt dynamics so far mainly an issue in a few
peripheral countries.
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Debts can overburden monetary policy
 Tight fiscal policy necessary when debts are
large.
 With fiscal policy unable to support demand,
monetary policy risks being overburdened.
 Not easy to adopt more expansionary monetary
policy when interest rates are at zero.
 Relevant to euro area.
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Debts and financial system
 Perceptions of sovereign credit risk can impair
the monetary transmission mechanism.
 Often the most serious problem.
 Of direct relevance to euro area.
 Several mutually reinforcing channels:
1. Price.
2. Liquidity.
3. Balance sheet.
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Debts and financial system (2)
I. Price channel:
 Sovereign yields influence lending rates by affecting
banks’ cost of funding.
 Euro area sovereign risk raised government bond
yields and led to higher funding cost in a number of
countries.
 Risk that fluctuations in sovereign risk premiums
dominate monetary policy signals.
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Bank funding costs and policy rate
13
Long-run yields and ECB policy rate
14
12
10
8
6
4
2
0
2003Jan
2005Jan
2007Jan
Irish 10-year yield
2009Jan
policy rate
2011Jan
2013Jan
2015Jan
German10-year yield
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Debts and financial system (3)
II. Liquidity channel:
 Government bonds are often used as collateral for
banks’ borrowing.
 Sovereign credit risk leads to increased haircuts and
reduces liquidity.
 Can lead markets to freeze up.
 Can restrict banks’ capacity to lend.
 Did increase banks’ reliance on euro system funding as
collateral rules are more favourable.



Monetary financing.
Strengthens link between sovereign and banks.
Risk to ECB’s balance sheet.
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Yields and haircuts on 10-year government
bonds
16
Increased use of government securities as
Eurosystem collateral
500
450
400
350
300
250
200
150
2008
2009
2010
2011
2012
2013
2014
2015
Government securities
Note: EUR billion, after valuation and haircuts. Includes central and regional government debt
Source: ECB, own calculations
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Debts and financial system (4)
III.Balance sheet channel:
 Higher yields and lower bond prices reduce bond
holders’ net wealth.
 Banks hold large amounts of domestic public debt;
falling net wealth reduce their capacity to lend.
 Borrowers’ credit standing impaired, reducing their
capacity to borrow.
 Financial intermediaries net worth declines, raising
credit risk in financial markets.
18
Sovereign and bank downgrades
Ireland
Ireland
BOI
Italy
AIB
Italy
UniCredit
Intesa San Paolo
Source: Moody’s ratings from Bloomberg, own calculations
19
Euro-area banking CDS spreads versus
sovereign CDS
Source: Bloomberg
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Conclusions
 Large public debts are problematic from a
monetary policy perspective.
 Can be inflationary, if combined with political
instability and lack of central bank independence.
 Sovereign risk impairs the functioning of the financial
system and weakens the monetary transmission
mechanism.
 Easier to pursue monetary policy in euro area if
public debts were reduced.
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