This paper presents a dynamic model of currency crises with fiscal
insolvency as the fundamental generating the crisis, as in generation one
models. However, in constrast to generation one
models, a crisis is not inevitable; if one occurs, it need not be preceded by
money-financed government deficits; and an increase in money growth is not
necessary to restore solvency. Fiscal policy is assumed to follow a passive
stochastic rule, allowing monetary policy to fix the exchange rate. There is an
upper bound on the long-run value for surplus, implying that debt has risk.
Stochastic fiscal shocks and changes in expectations of future fiscal
commitments can raise current desired debt or reduce expected future surpluses.
Should the government's desired debt exceed the present-value of expected
future surpluses, agents refuse to lend into this position of insolvency. The
sudden stop of capital inflows creates a crisis. Equilibrium can be restored
with some combination of fiscal reform and devaluation to restore fiscal
solvency. The model can explain a wider variety of crises than generation one
models, including those involving sovereign default. It is applied to explain
crises in
Private-Sector Financial Crises in Emerging Markets (revised –December 2007)
Investment necessary for growth is risky and often requires external financing. For an emerging market, access to international credit markets is volatile and interest rates reflect risk of default. We present a model in which emerging market agents have access to a profitable two-period investment project of fixed size greater than their endowment. Credit market imperfections can magnify a small solvency problem into a financial crisis with widespread default and/or currency devaluation. In equilibrium, creditors offer single-period debt up to a ceiling based on expected future output. News about a negative productivity shock reduces the debt ceiling imposed by creditors, creating a sudden stop of capital flows. The sudden stop can be severe enough to trigger a debt crisis, when agents prefer default over debt repayment, and/or a currency crisis, as agents attempt to maintain desired consumption by swapping domestic currency for foreign currency to purchase goods. We also show that there are critical thresholds for parameters governing credit market imperfections that separate countries into a safe credit club with low interest rates and steady access and a risky club with high interest rates and volatile access.
A country entering a monetary union gives up
the right to determine its own monetary policy. Individual fiscal authorities
promise passive fiscal policy, allowing the central monetary authority to use
active monetary policy. Since a government, which can print its own money, can
honor its nominal debt unconditionally, entrance into a monetary union raises
new issues of potential fiscal insolvency. When there is an upper bound on the
magnitude of the surplus and stochastic shocks to the surplus, a government can
find itself in a position in which it cannot borrow to continue with its
desired passive fiscal policy. This paper considers the risk of a fiscal
financial crisis in a monetary union under alternative assumptions about how
the fiscal authority would respond. The response affects the timing and
probability of a crisis. We consider both outright default and policy
switching, whereby the fiscal authority in crisis switches to active fiscal
policy and the monetary authority switches to passive monetary policy. We apply
the model to estimate fiscal risk in the European Monetary Union. Using panel
estimates of the parameters in the surplus rule and initial values for
government debt and the primary surplus, we simulate fiscal risk under the two
alternative fiscal responses to a crisis. We find that countries with initial
values bound by the Maastricht Treaty limits are safe, while countries like
It is widely believed that the Fiscal Theory of the Price Level (FTPL) does not work in an environment in which initial government debt is zero. This paper demonstrates that this view is incorrect when asset markets are incomplete and fiscal policy is stochastic. In particular, it is possible to define a stochastic non-Ricardian fiscal policy for which the set of equilibrium stochastic price processes under non-Ricardian fiscal policy is a subset of the set of equilibrium stochastic price processes under Ricardian fiscal policy.
Financial Liberalization and Banking Crises in Emerging Economies
co-authored with John Jones (May, 2007), Journal of International Economics.
Financial liberalization often leads to financial crises. This link has usually been attributed to poorly designed banking systems, an explanation that is largely static. In this paper we develop a dynamic explanation, by modeling the evolution of a newly-liberalized bank's opportunities and incentives to take on risk over time. The model reveals that even if a banking system is well-designed, in the sense of having good long-run properties, many countries will enjoy an initial period of rapid, low-risk growth and then enter a period with an elevated risk of banking crisis. This transition emerges because of the way in which the degree of foreign competition, the marginal product of capital, and the bank's own net worth simultaneously evolve.
Public Default Dynamics (revised –August 2006)
This paper provides a dynamic model of a
public debt crisis in which fiscal insolvency is the cause. The insolvency is
created by a combination of a passive fiscal policy with an upper bound on the
long-run budget surplus, yielding risky government debt, and a string of bad
luck. As debt rises and a crisis approaches, the interest rate rises, due to a
risk premium on debt in anticipation of possible default. A position, in which
the contractual value of debt under passive fiscal policy exceeds the maximum
expected present-value surplus, is infeasible. Should passive fiscal policy
require such a point, a crisis occurs. Crisis resolution includes a promise of
fiscal reform, with a switch to active fiscal policy as in the Fiscal Theory of
the Price Level (FTPL). The switch creates larger near-term surpluses, which
serve to raise the expected present-value surplus, and greater exchange rate
flexibility, which eliminates the default premium on debt. If the present-value
surplus is still too low relative to debt after the policy switch, default is
necessary.
Monetary Policy in a Fiscal
Theory Regime (June 2004)
This paper considers the behavior of monetary
policy in a regime in which the "Fiscal Theory of the Price Level"
(FTPL) applies and in which the government issues long-term debt. Cochrane
(2001) shows that the fiscal authority can use a commitment to maintain a fixed
maturity structure of government debt to fully determine the impact and dynamic
effects of present-value-surplus shocks on inflation in a cashless economy. We
show that in a monetary economy, in which Cochrane’s fiscal commitment to
maturity structure is replaced with a monetary commitment to a state-contingent
interest rate rule, the monetary authority becomes responsible for the timing
of inflation. We derive interest rate rules, which minimize the variance of
inflation around a target, and show that the interest rate will respond
positively to shocks raising inflation and to shocks raising output above
trend, as with a Taylor Rule.