The ECB’s collateral framework
Central banks accept debt of their own governments without reservations. This favorable treatment of sovereign debt in a central bank’s collateral framework is the reason why in advanced economies sovereign debt is considered a safe asset. But the ECB’s collateral framework differs from other central banks’: it relies on external credit ratings of each member’s debt in order to determine the eligibility of such debt and the haircut it imposes: debt with a high credit rating is
accepted as collateral without reservations and with negligible haircuts; for debt with lower credit ratings a higher haircut is implied. This differential treatment of sovereign debt has an important effect on the liquidity premium.
In this paper Lengwiler and Orphanides examine the implications of a collateral framework that considers sovereign debt to be eligible collateral if the economy’s debt ratio falls below some threshold, but not eligible otherwise. They use a stylized general equilibrium banking model where higher debt ratios are associated with lower credit ratings and overall creditworthiness. This feature serves as a proxy for linking collateral eligibility to credit ratings.
[W]e show that introducing external assessments and endogenous measures of perceived creditworthiness in this fashion has some potentially severe inadvertent side effects. First, this practice gives rise to undesirable cliff effects, which in turn can generate multiple equilibria: A good equilibrium with low debt and high perceived creditworthiness can coexist with a worse equilibrium (from a welfare perspective), with higher debt and lower perceived creditworthiness. Second, in a stochastic environment when an adverse shock to the economy can stress public finances, such a collateral framework can induce an otherwise unnecessary default. In effect, a harsh collateral treatment of government debt can make public finance more fragile than necessary and become the cause of a sovereign
debt crisis.
Collateral Framework: Liquidity Premia and Multiple Equilibria
Authors: Yvan Lengwiler, Athanasios Orphanides
From: University of Basel, MIT
Optimal fiscal policy when government debt is used as collateral
How can a government issue public debt, which increases welfare by easing the underlying financial friction, without significantly lowering the liquidity premium and increasing the government’s cost of borrowing?
This is the question Angeletos et al. are exploring in this paper. They augment the basic Ramsey paradigm with a liquidity function for public debt. In their model the optimal fiscal policy is determined by the interplay of three forces: a) the desire to smooth taxes; b) the desire to ease the financial friction so as to improve private allocations; and c) the desire to preserve the financial friction so as to suppress the interest-rate cost of public debt. There exists a unique long-run level of public debt which requires a front-loaded tax response to government-spending shocks, instead of tax smoothing.
Public Debt as Private Liquidity: Optimal Policy
Authors: George-Marios Angeletos, Fabrice Collard, Harris Dellas
From: MIT, Toulouse School of Economics, University of Bern
