Wednesday, May 16, 2012

What to do when people expect the government to default on its debt

The situation in Greece is rapidly getting worse, with clear signs that a bank run is in the works, mainly because there is no party majority that would avoid a default on the public debt. In such a situation, what should the fiscal policy be? Clearly, the budgets have to be reduced dramatically as no one would be willing to lend to the government and the government can only pay with cash (which is not the new drachma, as no one will trust that either and we would have immediate hyperinflation and the complete collapse of public services). This is why the government has no choice but to honor its debts if it wants to continue offering public goods, and this is what the Greeks want, I think.

So then, what should happen if the government is committed to pay the debt, but the public does not believe it? For advice, we can turn to the recent paper by Francesco Caprioli, Pietro Rizza and Pietro Tommasino. Suppose economic agents eventually and gradually learn about the good dispositions of the government. They also believe there is a positive correlation between the level of debt and the probability of default. The consequence of these very reasonable assumptions is that government expenses need absolutely to be reduced after a negative tax revenue shock. The first reason is that the interest rate goes up and worsens the situation, the second is that the government needs to keep the debt low to avoid fueling more default expectations, not just today but also in the future due to inertia of beliefs. This is in stark contrast from a situation where the government can credibly commit to repaying the debt: then, debt can effectively be used to smooth out fluctuations in tax revenue.

Greece is so screwed.

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