Exorbitant Privilege, Debt Capacity, and the Eurozone: A Puzzle in Economic Theory

How different are reserve-currency issuing sovereigns with exorbitant privilege?

With the exception of the Great Contraction of 1929-1933, ever since 1914 with the beginning of World War I–no, ever since 1896 and the full-scale exploitation of the gold mines of the Witwatersrand–the rate of interest on the world’s fundamental monetary security, the bonds of the sovereign or four whose assets serve as global reserves, has invariably been less than the growth rate of the global economy’s potential output, and has often in real terms been less than zero. The deflation of 1929 to 1933 will never come again. Thus we now have 12 decades of experience of operating in international macroeconomic environment in which it is the exorbitant privilege of the world’s reserve currency-printing sovereigns not to have a government budget constraint–or perhaps not to have a government budget constraint as long as they do not use their privilege so much as to lose their reserve-currency status.

You would think that by now, after twelve decades, the dominant strain of thought in international macroeconomics would have incorporated this empirical regularity of exorbitant privilege into their models. To transfer a modicum, or perhaps more than a modicum, of debt off of the books of periphery governments and onto the books of reserve currency-printing sovereigns is a free lunch that we should be taking much more advantage of. But no.

I was going to write a piece explaining why the dominant view in international macro is what it is. But I can’t. So let me give up and declare analytical bankruptcy. Can anybody tell me why moving large amounts of debt onto the books of the reserve currency-issuers is not a no-brainer that has already been done?

Cf. Ken Rogoff:

Kenneth Rogoff: Economic Recovery Require Debt Restructuring or Rescheduling: “Eurozone leaders continue to debate how best to reinvigorate economic growth….

…Meanwhile, the leaders of the eurozone’s northern member countries continue to push for more serious implementation of structural reform. Ideally, both sides will get their way, but it is difficult to see an endgame that does not involve significant debt restructuring or rescheduling…. In general, neither pure austerity nor crude Keynesian stimulus can help countries escape high-debt traps…. debt rescheduling, inflation, and various forms of wealth taxation (such as financial repression), have typically played a significant role. It is hard to see how European countries can indefinitely avoid recourse to the full debt toolkit, especially to repair the fragile economies of the eurozone’s periphery.

The ECB’s expansive “whatever it takes” guarantee may indeed be enough to help finance greater short-term stimulus than is currently being allowed; but the ECB’s guarantee will not solve long-run sustainability problems. Indeed, the ECB will soon have to confront the fact that structural reforms and fiscal austerity fall far short of being a complete solution to Europe’s debt problems. In October and November, the ECB will announce the results of its bank stress tests. Because many banks hold a large volume of eurozone government debt, the results will depend very much on how the ECB assesses sovereign risk. If the ECB grossly understates the risks, its credibility as a regulator will be badly tarnished. If it is more forthright about the risks, there is a chance that some periphery countries might have difficulty plugging the holes, and will require help from the north. One hopes that the ECB will be forthright. It is high time for a conversation on debt relief for the entire eurozone periphery…

September 10, 2014

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