Sovereign debt and multiple equilibria Steinar Holden Department of Economics, UiO http://folk.uio.no/sholden/ ECON 4325 3 May 2013

Lower interest rates for EMU countries in 2099

But not in 2011 – what had happened?

Countries without national central bank are more vulnerable for debt crises Estimate 2011 – percent of GDP Budget balance Primary balance Gross debt Net debt Great Britain -8.8 -5.6 81 73 Spain -6.1 -4.4 67 56 Kilde: IMF Fiscal Monitor September 2011 In spite of this, Great Britain has been borrowing at 2.5 % interest rate, and Spain at over 5%

Debt in ”foreign currency” – without national central bank

Total financing needs 2012 maturing debt green, budget deficit blue

Two equilibria Good equilibrium Bad equilibrium The market expects the debt to be paid The interest rate is low, and the debt can be paid Bad equilibrium The market fears that the debt will not be paid The interest rate becomes so high that debt is not paid Self fullfilling expectations can give rise to a liquidity crisis => vast costs The central bank can buy government bonds Bad equilibrium can be avoided

Central banks buy govt debt

Fiscal policy and the financial crisis

The Walter’s effect – monetary policy in a monetary union The same nominal interest rate prevails throughout the EMU A country with a booming economy will have higher wage and price growth Lower real interest rate will stimulate the boom A country in a downturn will have lower wage and price growth Higher real interest rate will amplify the downturn Unavoidable destabilizing mechanism

Trade balance in the euro area

Increasing public debt in advanced economies