"Simon Wren-Lewis is puzzled by a Ken Rogoff column that sorta-kinda defends Cameron’s austerity policies. His puzzlement, which I share, comes at several levels. But I want to focus on just one thing: Rogoff’s assertion that Britain could have faced a southern Europe-style crisis, with a loss of investor confidence driving up interest rates and plunging the economy into a deep slump.
As I’ve written before, I just don’t see how this is supposed to happen in a country with its own currency that doesn’t have a lot of foreign currency debt – especially if the country is currently in a liquidity trap, with monetary policy constrained by the zero lower bound on interest rates. You would think, given how many warnings have been issued about this possibility, that someone would have written down a simple model of the mechanics, but I have yet to see anything of the sort.
Let’s start with something like a canonical model – a model in which there’s an IS curve representing the effects of interest rates on demand, and monetary policy is described by some kind of Taylor rule. David Romer calls this the IS-MP model, and it looks something like this at a given point of time:
Here the MP curve represents the central bank’s response function for a given rate of inflation, with rates rising if output goes up a la Taylor. The flat section represents the zero lower bound.
As Romer points out in his notes, this can be reinterpreted as an open-economy model if we let capital flows be influenced by the exchange rate (most international econ types tend to think in terms of stocks rather than flows, but it doesn’t really matter here), so that a lower interest rate leads to currency depreciation. In this case the IS curve includes the effect of a weaker currency in promoting net exports.
Now suppose that investors turn on your country for some reason. This can be represented as a decline in capital inflows at any given interest rate, so that the currency depreciates. If you have a lot of foreign-currency-denominated debt, this could actually shift IS left through balance-sheet effects, as we learned in the Asian crisis. But that’s not the case for Britain; clearly, IS shifts right. If LM doesn’t shift, the interest rate will rise, but only because the loss of investor confidence is actually, through depreciation, having an expansionary effect.
We could modify this conclusion if the central bank is worried about the inflationary effect of depreciation, so that MP shifts left. In this case we could, possibly, have a contractionary effect of lost investor confidence – but the channel runs through the inflation fears of the central bank, which doesn’t seem to be at all what Rogoff or others are talking about:
Furthermore, suppose that we start in a liquidity trap. In that case monetary policy is initially tighter than the central bank would like, so that even if MP shifts left it won’t matter unless the shift is very large:
My point is that what sounds like a straightforward claim – that loss of foreign confidence causes a contractionary rise in interest rates – just doesn’t come out of anything like a standard model. If you want to claim that it will happen nonetheless, show me the model!
Now, you might argue that IS-MP is a model of the short-term interest rate, and we’re talking about long-term rates here. But long rates are largely determined by expected future short rates, so this argument doesn’t make sense unless you have some story about why short rates should rise somewhere along the way.
Furthermore, as Wren-Lewis says, even if there is somehow a squeeze on long-term bonds, why can’t the central bank just buy them up? Yes, this is “printing money” – but when you’re in a liquidity trap, that doesn’t matter. (Alternatively, you can take a consolidated view of the government and central bank balance sheets, in which case what we’re effectively doing is refinancing at the zero short-term rate.)
I know that many people find this line of argument, in which a loss of investor confidence is if anything expansionary, deeply counterintuitive. But macro, and especially liquidity trap macro, tends to be like that. So don’t give me your gut feelings; give me a coherent story about who does what, i.e. a model. I eagerly await a response."
As I’ve written before, I just don’t see how this is supposed to happen in a country with its own currency that doesn’t have a lot of foreign currency debt – especially if the country is currently in a liquidity trap, with monetary policy constrained by the zero lower bound on interest rates. You would think, given how many warnings have been issued about this possibility, that someone would have written down a simple model of the mechanics, but I have yet to see anything of the sort.
Let’s start with something like a canonical model – a model in which there’s an IS curve representing the effects of interest rates on demand, and monetary policy is described by some kind of Taylor rule. David Romer calls this the IS-MP model, and it looks something like this at a given point of time:
As Romer points out in his notes, this can be reinterpreted as an open-economy model if we let capital flows be influenced by the exchange rate (most international econ types tend to think in terms of stocks rather than flows, but it doesn’t really matter here), so that a lower interest rate leads to currency depreciation. In this case the IS curve includes the effect of a weaker currency in promoting net exports.
Now suppose that investors turn on your country for some reason. This can be represented as a decline in capital inflows at any given interest rate, so that the currency depreciates. If you have a lot of foreign-currency-denominated debt, this could actually shift IS left through balance-sheet effects, as we learned in the Asian crisis. But that’s not the case for Britain; clearly, IS shifts right. If LM doesn’t shift, the interest rate will rise, but only because the loss of investor confidence is actually, through depreciation, having an expansionary effect.
We could modify this conclusion if the central bank is worried about the inflationary effect of depreciation, so that MP shifts left. In this case we could, possibly, have a contractionary effect of lost investor confidence – but the channel runs through the inflation fears of the central bank, which doesn’t seem to be at all what Rogoff or others are talking about:
Now, you might argue that IS-MP is a model of the short-term interest rate, and we’re talking about long-term rates here. But long rates are largely determined by expected future short rates, so this argument doesn’t make sense unless you have some story about why short rates should rise somewhere along the way.
Furthermore, as Wren-Lewis says, even if there is somehow a squeeze on long-term bonds, why can’t the central bank just buy them up? Yes, this is “printing money” – but when you’re in a liquidity trap, that doesn’t matter. (Alternatively, you can take a consolidated view of the government and central bank balance sheets, in which case what we’re effectively doing is refinancing at the zero short-term rate.)
I know that many people find this line of argument, in which a loss of investor confidence is if anything expansionary, deeply counterintuitive. But macro, and especially liquidity trap macro, tends to be like that. So don’t give me your gut feelings; give me a coherent story about who does what, i.e. a model. I eagerly await a response."
