Kocherlakota Suggests It May Be Time For Fed To Consider "Bailing Out", Or At Least LBOing, America

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We can only assume this is some evil April Fool's joke: in a speech, titled appropriately: "Central Bank Independence and Sovereign Default" given at Wharton, Minneapolis Fed's Kocherlakota who now it can be put to rest was well aware of what today's NFP number will be, says the following: " I’ve argued that even if the fiscal authority borrows
exclusively in its country’s own currency, the central bank can have a
large amount of control over the price level. But the central bank can
only achieve that control if it is willing to commit to letting the
fiscal authority default. Such a commitment may expose the country to
risks of short-term and medium-term output losses. How this trade-off
should best be resolved awaits future research. But I suspect that it
may be optimal for central banks to guarantee fiscal authority debts in
some situations
." In other words, if this is really a prevailing mode of thought within the Fed, very soon we may witness the first ever Leveraged Buyout by a central bank of a sovereign, leading to advent of the concept known as the Full Faith and Credit Of The Chairsatan. It will also certainly cement the perception of the Fed as an "independent" organization. And one wonders why gold is well on its way to recouping today's losses.

From: Central Bank Independence and Sovereign Default

Narayana Kocherlakota - President
Federal Reserve Bank of Minneapolis

Wharton Conference
Philadelphia, Pennsylvania

Sargent and Wallace published their classic “Some Unpleasant Monetarist Arithmetic” in the Minneapolis Fed’s Quarterly Review
in 1981. Since that date, there has been a growing appreciation of the
role of fiscal policy in the determination of the price level. The idea
is a simple one. Consider a government that borrows only using
non-indexed debt denominated in its own currency. There is an
intertemporal government budget constraint that implies that the current
real value of government liabilities — including the monetary base —
must equal the present value of future real surpluses. Because the
liabilities are nominal and non-indexed, the government budget
constraint provides a linkage between the public’s assessment of future
real tax collections and government spending and the current price
level.

I like John Cochrane’s analogy here.2
He thinks of money and government bonds as being like stock in a
company. Just like a firm’s stock, money and bonds implicitly represent
claims to the ownership of the government’s stream of surpluses. And
just like with financial assets, the variations in their prices are
fundamentally linked to variations in the present discounted value of
government profits — that is, surpluses.3

This simple insight has rather profound consequences for how we think
about inflation. Inflation is no longer “always and everywhere a
monetary phenomenon”. Instead, even apparently independent central banks
may not have control of the price level. Thus, if the public begins to
think that the fiscal authority is behaving irresponsibly, that belief
will push upward on the price level.

However, in the existing literature, the analysis of fiscal effects
on the price level is typically based on the presumption that a fiscal
authority will never default on liabilities denominated in its own
currency. In my remarks today, I will relax this assumption. Once I do
so, it will become clear that a sufficiently tough central bank does
have the ability to control the price level, regardless of the behavior
of the fiscal authority. 4
I will argue that its ability to do so hinges on the nature of its
response to the possibility of default on the part of the fiscal
authority. I will talk about some of the short-run versus long-run
tensions involved in that response. Throughout, I will refer to the
central bank as CB and the fiscal authority as FA. I will refer to the
currency as being dollars, but that should not be viewed as suggesting
that I am talking about the United States — or Australia.

Let me start by describing a simple CB policy: a commodity price peg.
Suppose the central bank holds X ounces of gold. It commits to being
willing to buy and sell p dollars for each ounce of gold, and has a monetary base of $pX. This policy successfully ties the price level to variations in the price of gold, regardless of the behavior of the FA.

What impact does this policy have on the FA? Now, when the FA borrows
in dollars, it is essentially borrowing in a real commodity: gold. All
of the FA’s debt is essentially indexed to the price of gold, and it is
certainly conceivable that various shocks could lead the FA to default
on those obligations.5

Of course, as I have argued elsewhere, this simple policy is generally viewed as suboptimal by macroeconomists. 6 In contrast, suppose that the CB follows an aggressive Taylor rule when determining the path of the short-term interest rate. 7 That policy pins down an inflation path in the usual way, regardless of the FA’s fiscal plans.8
However, given that inflation path, the FA’s nominal debt is now
actually real. This means that if the FA is faced with an unexpected
decline in its current and expected future real surpluses, it will be
forced to default.9

Thus, once we allow for the possibility of default by the FA, a
sufficiently tough CB can have considerable control over the price
level. Of course, I’ve been arguing through examples. It would be more
interesting to deliver a fuller characterization of the term
“sufficiently tough” — but I’m not going to attempt to do so. Instead,
in what follows, I’ll discuss some aspects of the CB’s response to a
particularly critical situation.

Suppose the FA owes $10 billion on a given Friday. It plans to repay
that loan by auctioning new debt on the preceding Monday. However, when
it auctions off the new debt, it finds that it can only raise $5
billion. The FA is now in danger of defaulting on its Friday obligation
of $10 billion.

It is at this stage that the level of commitment of the CB to its
chosen inflation path will be severely tested. The FA will ask the CB to
take some action that will allow the FA to raise an additional $5
billion on Wednesday. There are many possible actions. The FA might ask
the CB to intervene by setting a floor on the price of debt in the
Wednesday auction. But there are less overt approaches. For example, the
CB can commit to a price peg for the FA’s debt in the secondary market
for that debt.

In any event, if the CB does intervene in some way to ensure the FA’s
solvency, the CB no longer can be said to have independent control over
the price level. If the CB’s intervention was largely unanticipated by
markets, expected inflation will rise after the CB’s intervention. Then,
incipient fiscal insolvency has triggered inflationary pressures. Of
course, markets may well have already assigned a positive probability to
the possibility that the CB might intervene in this kind of scenario.
If so, then past inflation was already influenced by the markets’
expectations of this fiscal policy scenario.

Should the CB be required to never intervene in this sort of
insolvency scenario? I’ve argued that a ban on these interventions will
give the CB more independence in its control over the price level. For
those who think of CB independence as being the foundational element of
macroeconomic policy, that pretty much settles the question.

But I see a couple of reasons for caution here. It is certainly
conceivable that FA insolvency can be triggered by shocks that are well
outside of the control of the FA itself. And, empirically, FA insolvency
is associated with large short-term and even medium-term declines in
output. Should the CB be prepared to drive the FA into insolvency given
the possible adverse economic impact on the country?

More subtly, regardless of the FA’s solvency, sovereign debt issues
can fail simply through a co-ordination failure among investors. If I,
as an investor, don’t anticipate that others will buy into the debt
issue, I won’t either. In this sense, sovereign debt issues may be
susceptible to suboptimal “runs”. The CB can eliminate this possibility
by ensuring the nominal promises of the FA whenever the FA is threatened
with default.

Thus, I see trade-offs. On the one hand, the CB is known to be
willing to intervene to keep the FA solvent, then inflation is
necessarily shaped by fiscal considerations and by the short-run
incentives of elected officials. We know from many years of theoretical
and empirical research that this effect is not a desirable one. On the
other hand, if the CB is fully committed to allow the FA to default if
necessary, then even optimal debt management by the FA may end up
exposing the country to troubling risks.

Let me wrap up. I’ve argued that even if the fiscal authority borrows
exclusively in its country’s own currency, the central bank can have a
large amount of control over the price level. But the central bank can
only achieve that control if it is willing to commit to letting the
fiscal authority default. Such a commitment may expose the country to
risks of short-term and medium-term output losses. How this trade-off
should best be resolved awaits future research. But I suspect that it
may be optimal for central banks to guarantee fiscal authority debts in
some situations. If so, we again have to think of price level
determination as something that is done jointly by the fiscal authority
and the central bank — just as Sargent and Wallace taught us 30 years
ago.