Crunch Time: Fiscal Crises and the Role of Monetary Policy
Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders lead to higher sovereign interest rates which in turn make the debt problems more severe. We analyze the recent experience of advanced economies using both econometric methods and case studies and conclude that countries with debt above 80% of GDP and persistent current-account deficits are vulnerable to a rapid fiscal deterioration as a result of these tipping-point dynamics. Such feedback is left out of current long-term U.S. budget projections and could make it much more difficult for the U.S. to maintain a sustainable budget course. A potential fiscal crunch also puts fundamental limits on what monetary policy is able to achieve. In simulations of the Federal Reserve's balance sheet, we find that under our baseline assumptions, in 2017-18 the Fed will be running sizable income losses on its portfolio net of operating and other expenses and therefore for a time will be unable to make remittances to the U.S. Treasury. Under alternative scenarios that allow for an emergence of fiscal concerns, the Fed's net losses would be more substantial.
This paper was written for the U.S. Monetary Policy Forum, New York City, February 22, 2013. We thank Anil Kashyap for helpful comments. We also thank Matthew Luzzetti, Rumki Majumdar, and John Abraham for their substantive contributions to our analysis and Richard Cunniff for editorial assistance. The views expressed here are ours alone and do not necessarily reflect those of the institutions with which we are affiliated. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
James D. Hamilton
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Consulting: Federal Reserve Bank of New York, Bank of Korea; National Bureau of Economic Research, FDIC, Interamerican Development Bank; 4 hedge funds, BTG Pactual, Gavea Investimentos; Reserve Bank of Australia, Federal Reserve Bank of San Francisco, Einaudi Institute, Bank of Italy
Teaching: Study Center Gerzensee, Swiss National Bank
Speeches: Lexington Partners; Tudor Investment, Brevan Howard, UBS, Pension Real Estate Association; Goodwin Proctor, Penn State University, Villanova University, Shroeder’s Investment Management, Premiere, Inc, Muira Global, Bidvest, NRUCF, BTG Asset Management, Futures Industry Association, ACLI, Handelsbanken, National Business Travel Association, Goldman Sachs, Urban Land Institute, Deloitte, Barclays Capital, CME Group; Barclays Capiital, BNP Paribas, Fidelity Investments, Deutsche Bank,, Freeman and Co., Bank America, Treasury Mangement Association, International Monetary Fund; Kairos Investments, Deloitte and Touche, Instituto para el Desarrollo Empreserial de lat Argentina, Handelsbanken, Danske Capital, WIPRO, University of Calgary, Pictet & Cie, Zurich Insurance Company, Central Bank of Chile
Co-Director, U.S. Monetary Policy Forum
Advisory Committee, Alfred P. Sloan Foundation’s Economic and Education Program
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U.S. Monetary Policy Forum: “Crunch Time: Fiscal Crises and the Role of Monetary Policy,” U.S. Monetary Policy Forum (Chicago: Chicago Booth Initiative on Global Markets, forthcoming)