Working Paper: CEPR ID: DP318
Authors: Francesco Glavazzi; Marco Pagano
Abstract: Under free capital mobility, confidence crises can lead to devaluations even when fixed exchange rates are viable, if fiscal authorities can obtain temporary money financing of deficits. During a crisis domestic interest rates increase, reflecting the expected devaluation. Rather than selling debt at punitive rates, fiscal authorities will turn to temporary money financing, leading to equilibria with positive probability of devaluation. These equilibria can be ruled out if the amount of debt maturing during the crisis is sufficiently small - a condition that can be met by reducing the stock of public debt, lengthening its average maturity and/or smoothing the time distribution of maturing issues.
Keywords: confidence crisis; collapse of exchange rate regimes; debt management; public debt maturity; EMS; financial liberalization
JEL Codes: 321; 431; 432
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| High amount of public debt maturing at a given time (H63) | Increase probability of a confidence crisis (E32) |
| Increase probability of a confidence crisis (E32) | Speculative attack on the central bank (E49) |
| Speculative attack on the central bank (E49) | Devaluation (F31) |
| Lengthening average maturity of public debt (H63) | Decrease probability of a confidence crisis (D80) |
| Smoothing time distribution of maturing issues (C41) | Decrease probability of a confidence crisis (D80) |
| Treasury reliance on temporary money financing during a crisis (H12) | Increase domestic interest rates (E43) |
| Increase domestic interest rates (E43) | Reflect expectations of devaluation (F31) |
| Interaction between domestic interest rates, treasury actions, and public expectations (E43) | Heightened risk of devaluation during confidence crises (F31) |