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When a country must borrow in foreign currency—a condition economists have labeled “original sin”—the consequences of an economic shock can be severe and swift. Sophisticated investors in sovereign debt immediately calculate the heightened risk of default. Interest rates spike, chilling economic growth and possibly tipping the borrower into a “rollover crisis” where further borrowing is off the table, culminating in a rational choice to default on its sovereign debt.
Countries that face the same shock but are able to borrow in their own currency would likely avoid these dire consequences. Part of the reason is the potential for higher inflation to erode the real value of domestic-currency debt. But diluting debt through inflation is analogous to default. As a matter of standard economic theory, interest rates should rise, all else equal, to the same degree as they do with foreign-currency borrowers. In general, however, they don’t.
One major reason, writes Minneapolis Fed Monetary Advisor Marco Bassetto, is the different audiences reacting to economic news in the cases of domestic and foreign-currency borrowers. Bassetto models and measures these effects in new research with Carlo Galli of Universidad Carlos III de Madrid and Minneapolis Fed Research Analyst Jason Hall (Minneapolis Fed Staff Report 680, “The Role of Dispersed Information in Maintaining Low Interest Rates”). The research pertains not just to developed economies like the U.S., the United Kingdom, and Japan but to the increasing number of emerging market governments, including in sub-Saharan Africa, now able to borrow in their own currencies.
The staff report extends directly from work published by Bassetto and Galli in the American Economic Review in 2019. The same intuition is at the center of both works: A government with debt in its own currency and sufficient fiscal credibility can temporarily mask the impact of negative information—thanks to a broader public that does not fully perceive the connection between debt, fiscal news, and higher inflation. The new staff report builds on the earlier paper by deepening the model and using data from the UK and Argentina to show how much information frictions matter in practice, especially for interest rate volatility.
Different paths to default, different audiences for news
When a shock strikes a government that borrows in a foreign currency, the primary audience is limited to banks, hedge funds, and other well-informed traders of international sovereign debt. They efficiently translate any new information into an assessment of default risk, with the direct and immediate effect of driving up interest rates facing the sovereign borrower.
For a government borrowing in domestic currency, on the other hand, the risk is not outright default but an implicit, indirect “default” via inflation. In this case, a much more diverse audience is processing the incoming economic news. There are still informed investors who promptly update their outlook and pricing. But the path from bad news to inflation depends on the actions and expectations of a much broader group of households and firms. As modeled by Bassetto, Galli, and Hall, this group is less informed about the current and future deficits and their long-run fiscal consequences. If the public’s inflation expectations are well anchored based on prior experience, these expectations tend to remain anchored in the near term.
Even sophisticated bond traders temper their reactions to the shock, because they understand that the general population has only a fuzzy understanding of the downstream effects of incoming news. The overall effect is to dampen the impact of any news that relates to the government’s ability to repay. When debts are partly monetized in this context of asymmetric information, the economists find that the full impact on interest rates is postponed. This logic helps explain why two countries hit by the same shock might experience different interest rate effects, depending on the currency of their debt. “The presence of information frictions creates a difference in the sensitivity of debt prices to shocks depending on whether default is explicit or implicit via inflation,” they write.
Rate volatility plummets in an economy with “dispersed information”
The economists formalize their analysis with a three-period, rational expectations model. In the domestic-currency case, the model is populated by two types of agents: sophisticated investors, and a mass of less informed “noise traders” (households and firms). In Period 1, the government auctions debt in domestic currency and agents have access to information about the government’s fiscal capacity. In Period 2, traders update their beliefs in a Bayesian fashion and trade the debt in a secondary market. In Period 3, the government repays. Crucially, the mass of households and firms do not perceive the implications of the fiscal capacity news in the first period; in the second period, they imperfectly recall the first period prices.
Bassetto, Galli, and Hall parameterize the model with financial, forecasting, and survey data from the United Kingdom. The UK has a deep market in inflation-protected investments, which helps the researchers isolate the effects of inflation in devaluing government debt.
The economists compare their model’s “dispersed information” economy with a counterfactual in which all agents are similarly informed and have the same recall of past prices. The economy with dispersed information experiences four-times-lower volatility in sovereign bond spreads in response to a shock. The average bond spread (the additional interest rate paid by the government above a risk-free alternative) is ultimately somewhat higher than in the counterfactual. But, the economists write, “by buying government bonds with newly created money, the central bank may drown a negative signal, potentially buying time to avoid the day of reckoning.”
They perform further tests of the model, including varying the fiscal solvency threshold at which the government can no longer honor the full debt, and scenarios in which the sovereign chooses not to borrow at all if spreads exceed certain levels. In one simulation, they apply data from default-prone Argentina to explore the tipping point when a domestic currency strategy—even if it were feasible—fails to be optimal. They find that when a government’s fiscal history is turbulent, domestic-currency borrowing can become prohibitively expensive or even impossible to place. The foreign-currency debt market—with its risk-neutral, hyperinformed lenders—becomes the only viable option. In this case, the long memories and slow-changing beliefs of the domestic population make domestic-currency borrowing untenable.
Do actual central banks monetize debt in the style of the model? Bassetto, Galli, and Hall offer two recent examples: Federal Reserve quantitative easing at the onset of COVID-19, and the 2022 intervention by the Bank of England to stabilize the market for gilts (UK bonds). While monetization was not the declared objective, it was among the effects.
The economists take care to emphasize that the effects of monetary efforts to “drown” bad news are only temporary. The capacity to do so can also be lost. “As fiscal sustainability becomes more questionable, the ability of a central bank to intervene and stabilize the market for government bonds without triggering a bout of inflation is initially valuable,” the economists write. “But a point comes at which this power is ineffective at keeping interest rates under control.”
Read the Minneapolis Fed staff report: “The Role of Dispersed Information in Maintaining Low Interest Rates”
Jeff Horwich is the senior economics writer for the Minneapolis Fed. He has been an economic journalist with public radio, commissioned examiner for the Consumer Financial Protection Bureau, and director of policy and communications for the Minneapolis Public Housing Authority. He received his master’s degree in applied economics from the University of Minnesota.
