Interactions between Soverign Debt Management and Monetary Policy Under Fiscal Dominance and Financial Instability

Abstract

This paper argues that serious fiscal vulnerabilities arising from many years of high government debt will create new and complex interactions between public debt management (PDM) and monetary policy (MP). The paper notes that, although their formal mandates have not changed, recent balance sheet policies of many Central Banks (CBs) have tended to blur the separation of their policies from fiscal policy (FP). The mandates of debt management offices (DMOs) have usually had a microeconomic focus (viz, keeping government debt markets liquid, limiting refunding risks etc). Such mandates have usually eschewed any macroeconomic policy dimension. For these reasons, all clashes in policy mandate between CBs and DMOs have been latent and not overt. The paper argues that under ‘normal’ circumstances, these distinct mandates have worked well. CBs and DMOs, as independent institutions with different objectives, responsibilities and functions, have usually enjoyed clear working relationships that functioned (often in the same markets) without policy conflicts. Both CBs and DMOs could serve the general interest best by executing their separate, specific mandates. It will be argued, however, that the financial and economic crisis has led to some blurring of lines between public debt management (PDM) and monetary policy (MP). DMOs have operated more extensively at the short end of yield curve, and CBs have been increasingly active in the same long government bond markets as DMOs. It will also be argued that during crisis periods, the different mandates appeared sometimes to be in conflict. There is no consensus about the macroeconomics of government debt management. But the economics profession need to re-focus on this subject and in particular re-examine the theoretical frameworks that are based on debt management neutrality. This issue needs to be more satisfactorily dealt with in the literature and, more generally, better understood by both policymakers and academics. It has become clear that the conventional, microeconomic focused PDM approach may conflict with wider, macro-economic considerations. Nevertheless, caution is warranted in drawing any implications for altering the current functional responsibilities of debt managers (DMs), central bankers (CBs) and fiscal authorities (FAs). A full debate about this would have to take account of not only the economics, but also political or institutional constraints. Appropriate governance mechanisms are important. There are practical advantages in arrangements that in practice serve to forestall short-sighted policies and hold specific institutions accountable for their mandates.

Keywords: Public Debt Management, Sovereign Debt Markets, Monetary Policy, Policy Mandates, Fiscal Dominance

JEL Classification: G15, G18, G28, H63, E40, E43, E61