Over the last year or so there has been an increasing amount of discussion about government debt, default, and monetary policy. For example, and I plead guilty to this as well, a number of people have remarked that Greece’s debt problem is made worse by the fact that they do not have their own currency. However, I have come to realize that I have a distinctly different view on this issue than others who make similar claims.
What I have in mind in talking about the importance of a country having its own currency is the sovereignty over monetary policy. Suppose that government debt and nominal income are both increasing, but the ratio between the two is not. Now suppose that one does not have sovereignty over monetary policy and that policy becomes tight without any change in fiscal policy. As a result, nominal income declines. To the extent that tax revenue is raised through income taxes, this implies a corresponding reduction in revenue and a larger budget deficit than initially planned. The larger budget deficit means a larger increase in the stock of government debt. The larger government debt coupled with lower nominal income causes the ratio between the two to get larger. Since this is a crude measure of the country’s capacity to pay back the debt, this change is potentially significant.
Now it is important to note here that I am not arguing that monetary policy should be used to adjust nominal income such that the ratio of government debt to nominal income remains unchanged or even reduced. Rather, what I am attempting to illustrate is that if monetary policy is responding to the nominal income (or inflation) in France or Germany, tighter policy will reduce nominal income in the periphery as well. In other words, the lack of sovereignty over monetary policy can potentially increase the debt-to-GDP ratio or force fiscal policy to effectively respond to changes in economic conditions of the surrounding Euro area. This has important implications for a country’s capacity to pay back their debt and therefore the potential for default.
The view that I put forth is not revolutionary. It is widely recognized in discussions of optimal currency areas. However, it seems that many (if not most) of the others that I see emphasizing the importance of a domestic currency and/or sovereign monetary policy are espousing a completely different view. Specifically, it seems that are a number of folks who suggest that it is impossible for the government to default on debt if it is denominated in the domestic currency. This is not the view that I put forth and it is not entirely clear to me that (1) this is true, or (2) that this would somehow be more beneficial than a default.
On this note, Megan McArdle has a pretty good round-up of some of these points. For example, regarding (1) she writes:
It isn’t even technically true–Zimbabwe eventually ran out of hard currency to buy the ink it needed to print the money to sustain its hyperinflation.
In addition, regarding point (2):
To be clear, I do not think that a classical default*, with or without hyperinflation, is very likely. But that is not the same thing as saying that it is impossible. Moreover, the dismissive way that Galbraith treats this problem looks only at the stock of debt, not the flow of funds. Inflation is only a good way to get out of your debts if you aren’t planning to borrow any more money.
But what I find most disturbing about Galbraith’s formulation is that it seems to imply that inflation is somehow a less worrying solution to the problem of debt than default is. But inflation merely redistributes the pain; it doesn’t really eliminate it. You can argue that a small amount of inflation is preferable to the alternatives, distributing the pain very broadly in order to avoid the intense dislocations of a sudden shock. I might even agree with someone who argued this. But small amounts of inflation are not going to rid us of $10 trillion in debt. And the pain of large amounts of inflation is extremely painful–arguably, more so, not less so, than technical default.
My only area of disagreement — and I am not even sure based on the context the extent to which we disagree — is in regards to the actual costs of inflation. I think that even modest inflation is going to be very costly and that even many economists ignore the full costs associated with inflation (see Leijonhufvud and Horwitz). Lago and Wright, for example, argue that the benefit of a reduction of inflation from 10 percent to 0 percent is worth 3 – 5% of consumption.
The takeaway from all of this is that sovereignty over monetary policy is important for government debt. While the ability to pay off the debt using newly created money renders default unlikely, if not impossible, it is far from clear that this solution would be any less costly.