How debt crises affect monetary policy

Sovereign debt crises—when governments are unable to repay money they’ve borrowed from abroad—are a recurring global problem. Greece and Spain. Argentina and Brazil. These and other nations have been beset by debt crises in recent decades.

Often, the painful solution has been draconian cuts in domestic spending plus sharp tax increases—steps that are politically unpopular and difficult to sustain. Ironically, such measures can also be counterproductive. By curbing domestic demand, they slow economic growth, drying up sources of government revenue for debt repayment.

These economic shocks inevitably affect prices and jobs. But central banks in these countries have been handicapped in addressing those effects because their standard model doesn’t account for sovereign default risk. It was developed for advanced economies that tend not to suffer such crises.

Fortunately, a new model is being developed to fill the void, with the potential to guide central bankers in nations that experience sovereign debt stress more often than they’d like.

Insight from a new model

Minneapolis Fed monetary adviser Cristina Arellano, with Yan Bai at the University of Rochester and Gabriel Mihalache at Stony Brook University, has built what the three economists call the “NK-Default” model. (See Staff Report 592.) It’s a hybrid that blends the central banker’s benchmark “New Keynesian” model with key elements from models that are used to analyze sovereign debt default. (“New Keynesian” theory is itself a blend of older concepts from John Maynard Keynes with insights from rational expectations plus nominal rigidity—the fact that wages and prices adjust gradually to shocks.)

The NK-Default model focuses on the interaction between monetary policy and sovereign debt—money the government borrows by issuing sovereign bonds. An independent central bank sets monetary policy through an interest rate rule with an inflation target. The government’s fiscal authority—its treasury—issues sovereign bonds to borrow from investors in other countries and international agencies like the International Monetary Fund (IMF).

By design, monetary policy affects domestic consumption, production, and inflation. But the economists’ key insight is that these are also affected by the risk of default. That parallel is central to understanding the interaction of fiscal and monetary policy. And it’s why incorporating sovereign risk into monetary models is essential for both fiscal and monetary authorities.

The NK-Default model has two primary mechanisms. The first is the effects of default risk on economic growth and inflation. Raising the risk of default, the model shows, will depress domestic consumption, ultimately leading to lower demand and decreased economic output. At the same time, raising default risk increases expectations for future inflation in the event of future defaults, which leads firms to increase inflation.

Why does higher default risk curb consumption? The simple version is that households anticipate that a debt crisis will negatively affect their future income, so they cut back on current purchases to save for later. Because prices don’t adjust quickly in response to lower demand, output falls when demand does.

In short, rising default risk can lead to recession with high inflation. Internalizing that reality, the fiscal authority will “discipline” its borrowing and default risk—that is, it will restrain its hunt for foreign capital. After all, governments borrow to facilitate growth, not retard it.

The other side of this—the second mechanism—is monetary policy. A central bank that targets inflation is also concerned with consumption, production, and employment. If rising default risk threatens economic growth but gives rise to inflation, central bankers face a tension for their monetary policy. In the jargon of economics, default risk amplifies “monetary friction,” grit that slows the economy’s churning gears, making it harder to stabilize prices.

Thus, by integrating sovereign default risk into a standard monetary policy, the hybrid blends two mechanisms in an emerging economy that seeks price stability while borrowing from abroad. It’s a new framework for designing monetary policy that accounts for the stifling force of default risk.

A Brazilian test

The economists use several empirical tests to gauge the model’s value. Among these: seeing if it can replicate patterns in data from emerging markets that have adopted standard New Keynesian models. They focus specifically on Brazil, a country that struggled with sovereign debt crises, but has been successful at maintaining low inflation.

The model replicates Brazil’s volatility data on several key indicators and also generates positive correlations seen in data between sovereign spreads (a measure of bond risk—the difference between yield on a nation’s bond and on a similar bond from a low-risk country) and interest rates, inflation, interest rates, exchange rates, and trade balances, and negative correlations between spreads and output.

In another experiment, they find that the NK-Default delivers more realistic results than similar models that lack either key feature—default risk or inflation target. It generates inflation and nominal interest rates that are more volatile than the standard central bank model that omits default risk, and it delivers lower spreads and debt accumulation than the sovereign default model that lacks price rigidity.

Further, they test the model against data before and after Brazil’s 2015 recession when output dropped by 6 percent. The economists feed their model with negative productivity shocks to generate a 6 percent decline and find that it generates increases in sovereign spreads, inflation, and nominal domestic interest rates that closely match Brazilian data from 2012 to 2018. (See figure, panels a, b, and c.)

Results from the NK-Default model closely match Brazilian data

It delivers similar trends in exchange rate depreciation, too, but with less volatility than seen in actual data, and it doesn’t replicate Brazil’s large depreciation in 2016.

They also run a “counterfactual” experiment with their model to gauge how Brazil’s economy would have fared had its central bank not tightened monetary policy in response to higher inflation. This looser policy would have moderated the recession somewhat, according to the NK-Default model, but would also have generated high inflation and higher sovereign spreads.

In summary, write the economists, “Our model matches the patterns of inflation, nominal domestic rates, and spreads during the Brazilian downturn of 2015. The counterfactual analysis highlights the role of monetary frictions in limiting borrowing and moderating crisis events.”

A useful addition

The economists run several robustness checks and extensions, seeing how the model performs with government debt denominated in local currency instead of foreign, and with alternative interest rate rules.

Ultimately, the results show that the standard paradigm for setting monetary policy is incomplete in the context of sovereign debt risk. And it demonstrates the importance of incorporating that reality into the benchmark model used by central banks in nations that frequently cope with debt crises. As Arellano noted in a presentation of the paper at a recent IMF conference, “We hope this will be a useful new tool for central banks in emerging markets.”