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CENTRAL BANK SUPPORT FOR GOVERNMENT DEBT IN A CURRENCY UNION

CENTRAL BANK SUPPORT FOR GOVERNMENT DEBT IN A CURRENCY UNION The no-bailout prescription of the Maastricht Treaty aimed at a complete mutual independence of monetary and fiscal policies in the European Monetary Union. But without a Lender of Last Resort for government debt, multiple equilibria in bond markets may ensue where default may emerge also for nonfundamental reasons. The stabilizing power of central bank interventions generally does not rest on real debt depreciation via inflation, as this policy, if expected, would increase interest rates and thus might trigger, and not prevent, a debt crisis. A more successful monetary support for government finance can be achieved through an exchange of public bonds and central bank reserves. As the latter are default-free, they bear lower interest rates than government obligations. A formal model is able to demonstrate that central bank interventions on the bond market can prevent the emergence of expectation-driven debt crises. Budget constraints and balance sheet considerations do not necessarily pose severe restrictions for such a monetary backstop policy. However in EMU, the ECB is not authorized to support national fiscal policy. This institutional dilemma calls for a return to a no-bailout regime, as realized in the US, but this step requires large debt cuts in advance. JEL codes: E58; G21; F34; H63 Keywords: currency union; financial market instability; Lender of Last Resort; central bank reserves; central bank budget constraint; Fiscal Theory of the Price Level http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Journal of Self-Governance and Management Economics Addleton Academic Publishers

CENTRAL BANK SUPPORT FOR GOVERNMENT DEBT IN A CURRENCY UNION

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Publisher
Addleton Academic Publishers
Copyright
© 2009 Addleton Academic Publishers
ISSN
2329-4175
eISSN
2377-0996
Publisher site
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Abstract

The no-bailout prescription of the Maastricht Treaty aimed at a complete mutual independence of monetary and fiscal policies in the European Monetary Union. But without a Lender of Last Resort for government debt, multiple equilibria in bond markets may ensue where default may emerge also for nonfundamental reasons. The stabilizing power of central bank interventions generally does not rest on real debt depreciation via inflation, as this policy, if expected, would increase interest rates and thus might trigger, and not prevent, a debt crisis. A more successful monetary support for government finance can be achieved through an exchange of public bonds and central bank reserves. As the latter are default-free, they bear lower interest rates than government obligations. A formal model is able to demonstrate that central bank interventions on the bond market can prevent the emergence of expectation-driven debt crises. Budget constraints and balance sheet considerations do not necessarily pose severe restrictions for such a monetary backstop policy. However in EMU, the ECB is not authorized to support national fiscal policy. This institutional dilemma calls for a return to a no-bailout regime, as realized in the US, but this step requires large debt cuts in advance. JEL codes: E58; G21; F34; H63 Keywords: currency union; financial market instability; Lender of Last Resort; central bank reserves; central bank budget constraint; Fiscal Theory of the Price Level

Journal

Journal of Self-Governance and Management Economics – Addleton Academic Publishers

Published: Jan 1, 2017

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