Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Why Prices Don't Respond Sooner to a Prospective Sovereign Debt Crisis

Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Why Prices Don't Respond Sooner to a Prospective Sovereign Debt Crisis

Article excerpt

1 Introduction

Recently, many developed countries have faced serious government debt problems in the midst of severe and persistent economic contractions. It is a politically difficult task for a government to increase taxes or lower purchases and engineer a fiscal consolidation. For a government that fails to generate a fiscal consolidation the alternative is default. Default can arise in one of two ways. One way is to suspend payments on its debt. Most sovereign debt is nominally denominated. This opens the door to a second form of implicit default. High inflation reduces the real value of outstanding government debt. We refer to either of these forms of default as a sovereign debt crisis.

How does news about the possibility of a future debt crisis affect prices today? Under the assumptions of rational expectations and complete markets, prices will respond instantly to the news. This result is at odds with what we see in some major economies. In Japan the gross debt-GDP ratio has risen from 60 percent to over 200 percent and yet the yield curve is flat and the price level is falling. In the United States government debt has also risen sharply and yet bond yields are low and inflation is muted.

The fact that prices have not responded is comforting to policy makers. On the one hand, sharp increases in yields and/or inflation can be a powerful impetus for the fiscal authority to get its house in order. On the other hand, if prices don't respond, there is a tendency for policy makers to perceive that the problem is not severe and to kick the can down the road.

The fact that prices are not responding today does not mean that there is not a significant risk of a future default. The objective of this paper is to use a model to make this point explicit. We show that the asset market structure plays a crucial role in determining how prices respond to an increase in the risk of a debt crisis. If markets are complete prices respond sharply and immediately to news about a prospective debt crisis. However, the response of prices can be delayed when financial frictions are modeled. News about the prospect of a future crisis has no impact on current prices. Instead prices increase sharply only shortly before the crisis event.

We consider two models: one where default is implicit and another where default is explicit. The particular model of implicit default we consider is a variant of the fiscal theory of the price level (FTPL) studied, for instance, by Leeper (1991), Sims (1994), Woodford (1995), Cochrane (2001), and Bassetto (2002), among others. Following the convention of this literature, we suppose that the government sets a sequence of real tax revenue as well as a sequence of nominal interest rates. In equilibrium the price level adjusts to satisfy the government's flow budget constraint in every period. For simplicity, we consider a finite horizon model in which the government collects taxes only in the last period. The amount of taxes collected in the last period are either high, [T.sub.H], or low, [T.sub.L]. The equilibrium price level in the last period is higher when the taxes collected in that period are smaller. We choose [T.sub.L] be so small that the equilibrium inflation rate is very large when the [T.sub.L] event occurs and refer to this outcome as a sovereign debt crisis.

Our model of beliefs and market structure builds on previous research by Geanakoplos (2003, 2010). Individuals have different beliefs about the probability of a debt crisis. When a debt crisis occurs, the inflation rate rises and, as a result, the ex-post real rate of return on government bonds falls. Thus, individuals who believe that the probability of a fiscal crisis is low are relatively optimistic about the rate of return on government bonds.

We examine the dynamics of the inflation rate under two asset market structures. The first structure is frictionless asset markets. Agents trade a complete set of contingent claims. …

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