The Mystery of the Printing Press: Self-Fulfilling Debt Crises and Monetary Sovereignty

Abstract

Does monetary sovereignty reduce the likelihood of default conditional on weak fundamentals and/or shield government debt markets from self-fulfilling speculative runs? Building on Calvo (1988), we specify a stochastic monetary economy where discretionary policymakers can default on debt holders through surprise inflation or by imposing discrete haircuts, at the cost of both output and budgetary losses. We show that the resort to the printing press to inflate away nominal debt per se rules out neither fundamental outright default nor confidence crisis. What matters is the ability of the central bank to swap government debt for monetary liabilities (e.g. cash and reserves), whose demand is not undermined by fears of default. The scope for successful central bank interventions in the debt market is however not unconstrained. We characterize conditions that must be met for alternative intervention strategies to be credible, i.e. feasible and welfare improving.

Keywords: Debt monetization, Lender of last resort, Seigniorage, Sovereign risk and default

JEL Classification: E58, E63, H63