FSR FINANCIAL STABILITY REVIEW APRIL 2012 PUBLIC DEBT, MONETARY POLICY 16 AND FINANCIAL STABILITY 110–016 FSR16.indb 1 06/04/2012 11:33:40 www.banque-france.fr “No part of this publication may be reproduced other than for the purposes stipulated in Article L.122-5.2° and 3° a) of the Intellectual Property Code without the express authorisation of the Banque de France or, where applicable, without complying with the terms of Article L.122-10. of the said code.” © Banque de France - 2012 ISSN 1636-6964 FSR16.indb 2 06/04/2012 11:33:47 FOREWORD ublic debt has reached unprecedented levels in advanced economies. It has become today the most pressing and diffi cult policy challenge that Western governments have to face. PAgainst this background, the Banque de France’s Financial Stability Review No. 16 focuses on ‘Public debt, Monetary policy and Financial Stability’. As usual, the Banque de France has invited prominent academics, practitioners and policy-makers to express their sometimes diverging viewpoints on this very topical issue in order to investigate the many aspects of public debt and their potential impact on sustainable growth, fi nancial stability and the conduct of monetary policy. Each paper sheds light on one or several of these aspects and attempts to draw some forward-looking policy conclusions. For ease of reading, they are classifi ed, after an introduction, into four parts, depending on the main themes: macro-economic, fi scal and operational context; fi nancial and regulatory aspects; monetary policy focus; regional and international dimensions. The introduction by C. Noyer stresses that unprecedented levels of public debt in advanced economies have been accompanied by equally unprecedented interventions by central banks, both in their magnitude and diversity. As we may have to live with high debt and non-standard monetary measures for some time, it is essential to maintain clarity of purpose and protect the two core pillars of central banking, inherited from the pre-crisis consensus: the focus on price stability and, its corollary, central bank independence. The fi rst part recalls the macro-economic, fi scal and operational context. As already experienced, high indebtedness of governments could imply the return of fi nancial repression, i.e. heavily regulated fi nancial markets and barriers to free circulation of capital, so that a process of fi nancial ‘de-globalisation’ may have just begun according to C. Reinhart. Various indicators of public fi nances have never been so weak for decades in many countries across the world, especially in advanced economies, but policy implications can be drawn for the short and medium terms (C. Cottarelli). To adapt, both public and private sectors need to better understand the dynamics of Western sovereign risk and pivot from a reactionary mode to a pre-emptive one (M. El-Erian). Part II deals with fi nancial and regulatory aspects, in particular the linkages between banks and public debt. A strong nexus between the credit risks of fi nancial sectors and their sovereigns has emerged in the Western economies (V. Acharya, I. Drechsler and P. Schnabl). While perfectly rational, public intervention in a crisis creates a range of moral hazard problems, with repercussions on incentives for both banks and sovereigns (R. Breton, C. Pinto, and P-F. Weber). This two-way interaction between banks and governments is critical for fi nancial stability and appropriate buffers should be built in good times to cushion the impact of bad times for both banks and sovereigns (J. Caruana and S. Avdjiev). However, in the on-going regulatory reform process, overemphasizing certain measures may give a false sense of security, e.g. high capital buffers according to R. Kroszner. Beyond considerations about possible amendments of the current rules to better refl ect sovereign risk, supervisory practices (e.g. stress tests) also appear as a powerful tool to address the issue (D. Nouy). Part III focuses on the impact for the conduct of monetary policy. Japan is an interesting case-study where lower potential growth and concerns about future taxes and pension burden have led to more private sector savings, defl ationary pressures and low interest rates (M. Shirakawa). To some, an accommodative monetary policy prior to a fi scal consolidation increases both the success likelihood and the credibility of the latter (T. Hellebrandt, A. Posen, and M. Tolle). And if the public sector becomes so indebted that its fi scal sustainability is potentially at risk, then monetary policy has no other choice but to be closely integrated with debt management and fi scal policy (C. Goodhart). Yet accommodative monetary policies raise credibility issues so that others, like N. Kocherlakota, recall the trade-off between potentially large fi nancial damages in Public debt, monetary policy and fi nancial stability Banque de France • Financial Stability Review • No. 16 • April 2012 FSR16_003_004_foreword.indd 3 19/04/2012 17:02:30 FOREWORD case of sovereign default on the one hand, but the necessity of allowing for default if the central bank is to be independent on the other hand. The difference between two forms of monetary dominance (‘soft’ and ‘hard’) might explain why the turmoil persists in several euro area countries while the United States or Japan, which have as much or more debt, have not been very affected (O. Jeanne). Yet contagion plays a crucial role in exacerbating sovereign debt problems in the euro area and has motivated several interventions by the European Central Bank (V. Constâncio). Monetary policy ought to keep infl ation expectations anchored containing tail risks to price stability on both sides: downside risks implied by this contagion and upside risks that could result from fi scal dominance (J. Matheron, B. Mojon, and J-G. Sahuc). Part IV highlights the regional and international dimensions of the debate, with a logical focus on the euro area. Some identify gaps in the institutional structure of the euro area (C. Sims), making it particularly vulnerable to the interdependence between banks and sovereigns (S. Merler and J. Pisani-Ferry) and explore the recent proposals to mutualise and repackage part of the sovereign debts (J. Tirole). As regards emerging economies, learning lessons from the past, Latin America has been able to sail through this period of world fi nancial turbulence relatively unscathed but economic interdependence explains global concerns and may justify some further action by the International Monetary Fund (A. Carstens). Improving the international fi nancial architecture should help the world reach a high growth equilibrium despite asymmetries in public debt levels and fi nancial developments according to J-P. Landau. Looking at the longer term indeed, the main challenge remains to re-fashion strategies so as to lay the basis for growth in an environment of fi scal consolidation in Europe, the United States and Japan (Tharman Shanmugaratnam). Public debt, monetary policy and fi nancial stability Banque de France • Financial Stability Review • No. 16 • April 2012 FSR16_003_004_foreword.indd 4 19/04/2012 17:02:34 CONTENTS ARTICLES Introduction 7 Central banking in a context of high public debt CHRISTIAN NOYER, Banque de France 9 Macro-economic, fi scal and operational context 15 Fiscal outlook and fi scal sustainability risks CARLO COTTARELLI, International Monetary Fund’s Fiscal Affairs Department 17 When Western sovereign risk is in play MOHAMED A. EL-ERIAN, PIMCO 29 The return of fi nancial repression CARMEN M. REINHART, Peterson Institute for International Economics 37 Financial and regulatory aspects 49 A tale of two overhangs: the nexus of fi nancial sector and sovereign credit risks VIRAL V. ACHARYA, ITAMAR DRECHSLER AND PHILIPP SCHNABL, New York University Stern School of Business 51 Banks, moral hazard, and public debts RÉGIS BRETON, CAROLINE PINTO AND PIERRE-FRANÇOIS WEBER, Banque de France 57 Sovereign creditworthiness and fi nancial stability: an international perspective JAIME CARUANA AND STEFAN AVDJIEV, Bank for International Settlements 71 Stability, growth and regulatory reform RANDALL S. KROSZNER, University of Chicago, Booth School of Business 87 Is sovereign risk properly addressed by fi nancial regulation? DANIÈLE NOUY, Prudential Supervisory Authority – Banque de France 95 Monetary policy focus 107 Contagion and the European debt crisis VÍTOR CONSTÂNCIO, European Central Bank 109 Monetary policy and public debt CHARLES GOODHART, London School of Economics, Financial Markets Group 123 Does monetary cooperation or confrontation lead to successful fi scal consolidation? TOMAS HELLEBRANDT, ADAM S. POSEN AND MARILYNE TOLLE, Bank of England 131 Fiscal challenges to monetary dominance in the euro area: a theoretical perspective OLIVIER JEANNE, Johns Hopkins University 143 Central bank independence and sovereign default NARAYANA KOCHERLAKOTA, Federal Reserve Bank of Minneapolis 151 The sovereign debt crisis and monetary policy JULIEN MATHERON, BENOÎT MOJON AND JEAN-GUILLAUME SAHUC, Banque de France 155 Sustainability of government debt: preconditions for stability in the fi nancial system and prices MASAAKI SHIRAKAWA, Bank of Japan 169 Public debt, monetary policy and fi nancial stability Banque de France • Financial Stability Review • No. 16 • April 2012 5 FSR16.indb 5 06/04/2012 11:33:47 CONTENTS Regional and international dimensions 183 The importance of confi dence in macroeconomic stabilisation efforts AGUSTÍN CARSTENS, Banco de México 185 Policies on sovereign debt JEAN-PIERRE LANDAU, Princeton University 191 Hazardous tango: sovereign-bank interdependence and fi nancial stability in the euro area SILVIA MERLER AND JEAN PISANI-FERRY, Bruegel and Université Paris-Dauphine 201 Rebuilding growth and optimism in a new fi scal era THARMAN SHANMUGARATNAM, International Monetary & Financial Committee, and Government of Singapore 211 Gaps in the institutional structure of the euro area CHRISTOPHER A. SIMS, Princeton University, Department of Economics 217 The euro crisis: some refl exions on institutional reform JEAN TIROLE, Toulouse School of Economics 225 PUBLISHED ARTICLES 243 Public debt, monetary policy and fi nancial stability 6 Banque de France • Financial Stability Review • No.