Can A Debt Crisis Happen To Countries With National Currencies?
The popular story — put out by everyone from Alan Greenspan to Erskine Bowles — runs like this:
1. Loss of investor confidence
What I keep asking is for someone to explain step 2 in a way that’s consistent with the fact that America, Britain, and Japan — unlike Greece — have their own currencies, and central banks that control short-term interest rates. Are you saying that they will raise these rates, and if so, why? Are you saying that long rates will become delinked from short rates? Why, and why can’t central banks prevent this just by buying long-term debt?
Krugman is partly right in arguing that having a national currency will, assuming that it has a floating exchange rate and that its debt is issued in that national currency, will almost completely end the risk of problems with financing large deficits. Because if private investors refuse to lend to such a government it can always turn to its central bank and ask it to "print" the money it needs and then lend the money to it. And since central banks can "print" unlimited amounts of money, this means that it can buy unlimited quantities of government debt securities.
However, while the risk of a debt crisis for a government with its own currency is indeed much smaller than for a government without it, it isn't zero, "Printing" a lot of money to finance government deficit spending can have the negative sideeffect of higher price inflation. And if the central bank worries that inflation is getting out of hand it might not be willing to bail out its government, at least not completely. Which is to say that in "step 2" the central bank will raise interest rates and allow long term rates even more because it wants to contain price inflation. And to bring down inflation at that point might require that not just nominal but also real interest rates are increased significantly, like in the early 1980s.