Here I go again, commenting on Krugman. But this time on a 5 year old talk on the risk that investors will lose confidence in the solvency of the US Treasury “CURRENCY REGIMES, CAPITAL FLOWS, ANDCRISES”. I think the talk about the risks of excessive budget deficits and unsustainable debt accumulation is much more relevant today than it was in 2013, since Republicans currently in power (not just Trump) will eliminate confidence that the US Treasury will pay its debts, if that is possible.
Krugman, however, thinks that a country which borrows in its own currency and allows the exchange rate to float can never be insolvent — the government can always monetized deficits and inflate away the value of its debt. He also argues that if investors lost faith in the US Treasury and decided Treasury notes and bonds would be worth little (either because of default or inflation) then the result would be a depreciation of the dollar.
He presents models in which this would stimulate demand for an economy in the liquidity trap (as the USA was in 2013). The counter argument is that this depreciation would cause a financial crisis in the USA. The key point of disagreement is explained by Krugman here:
Several commentators – for example, Rogoff (2013) — have suggested that a sudden stop of capital inflows provoked by concerns over sovereign debt would inevitably lead to a banking crisis, and that thiscrisis would dominate any positive effects from currency depreciation. If correct, this would certainly undermine the optimism I have expressed about how such a scenario would play out.
The question we need to ask here is why, exactly, we should believe that a sudden stop leads to a banking crisis. The argument seems to be that banks would take large losses on their holdings of government bonds. But why, exactly? A country that borrows in its own currency can’t be forced into default, and we’ve just seen that it can’t even be forced to raise interest rates. So there is no reason the domestic-currency value of the country’s bonds should plunge. The foreign-currency value of those bonds may indeed fall sharply thanks to currency depreciation, but this is only a problem for the banks if they have large liabilities denominated in foreign currency, a topic I address below
Here Krugman assumes investors are rational. Loss of confidence in the US Treasury doesn’t logically imply loss of confidence in banks. Larry Summers and Brad DeLong argue that investors are irrational and loss of one kind of confidence spills over to fear itself, which we have to fear. Knowing that economic agents are irrational but modeling rational ones implies that we know more than what is in our models.
I guess that the argument is that irrational fear due to sharp depreciation of the dollar could cause a banking crisis in the USA, even though it shouldn’t because US banks have dollar denominated liabilities. I further guess that it is true that general panic could cause a banking crisis in the USA — this doesn’t even have to be irrational — if there are multiple Nash equilibria assuming even Magic Nash rationality isn’t enough to rule out the possibility — a self fulfilling prophecy is a sunspot equilibrium not irrationality.
However, it does seem possible to rule out bad possibilities with rules. Economies used to have bank runs. Now they don’t because there is deposit insurance and/or a lender of last resort. The crisis of 2008 involved non-depository institutions which were acting as shadow banks transforming maturity so they had long term assets and short term liabilities. They weren’t covered by deposit insurance nor were they regulated much.
The Dodd-Frank act may have vastly reduced this risk. It is clear that the risk of financial crises can be very low — there wasn’t one n the USA during the long period of tight regulation from the 1930s through the 1970s. Nixon’s shift from fixed to floating exchange rates was a dramatic event in which the US government said it couldn’t keep a (non legally binding) promise. There was no banking crisis.
This means that the reasonable response to the concerns of Rogoff, DeLong, and Summers is to make sure regulations are sufficiently tight. Unfortunately, this too is highly relevant now. In addition to slashing taxes and raising spending, Congress also decided to relax regulations on medium sized banks with assets up to $249,999,999,999.99 . The argument is that this time the consequences of deregulation will be different.
It is too bad that a 5 year old discussion of possible problems is so topical. The change is that the possible risks have become probable now when Trump replaced Obama.