Default In A Liquidity Trap: Nick Rowe asks a good question: if we took our models seriously, what would we expect the effects of threatened default to be on the larger economy? His answer is that expected default should work just like expected inflation, which means that if anything it should be favorable right now. I think this is wrong — but in an interesting way…. [I]nflation doesn’t just erode the value of bonds; it also erodes the value of cash. And that’s why expected inflation can help in a liquidity trap: it makes sitting on cash less attractive. The threat of default doesn’t do that. As far as I know, we’re not talking about a loss of confidence in pieces of paper bearing pictures of dead presidents. And that’s why the threat of default isn’t equivalent — and not expansionary.
I see it slightly differently: a constant nominal interest rate, expected inflation has no effect on the money-bonds margin but makes people want to dump their bonds for goods and services--hence it is expansionary. But at a constant nominal interest rate, expected default makes people want to hold fewer bonds and more money as well. I think both the IS and LM curves should shift equally, and there should be no effect.
Paul goes further:
In fact, I’d argue that it is in fact contractionary, because it raises interest rates even in a liquidity trap…. [I]ntroduce the threat of default. This makes short-term debt worse than cash…. Yet… the Fed is ready to buy bonds to keep the rate at zero. So what happens? In a simple model, investors sell all short-term US debt to the Fed…. [S]uppose the Fed does in fact buy all the short-term debt. Then there is… still a “shadow” rate… that rate can easily go well above zero. This shadow rate, in turn, is — if I’m getting this right — the rate that feeds into the determination of longer-term rates. So we should expect rates to rise all along the term structure…
I think that nominal interest rates do rise, but the increase in nominal interest rates reduces spending on goods and services by exactly as much as the increase in the default probability raises it.
And then, of course, there is:
the question of what happens to the functioning of financial markets. Anil Kashyap tells me that everything will collapse, because repo depends on Treasuries as collateral. But why not just use cash instead? Hey, this is fun! But, you know, I’d rather not test the analysis in practice.
In practice, I think that repo would shift to cash as collateral, I think that the Fed would simply absorb the default risk from those who were worried about it, and that Nick Rowe might be right--as long as the Federal Reserve is willing to keep interest rates near zero by massively expanding its balance sheet.
Of course, the Fed could do the same thing if it were just to massively expand its balance sheet without any overhanging threat of default.
Odd nobody has worked this out fully yet. But I cannot find it anywhere...