Sovereign currency and long-term interest rates

ABSTRACT

This paper investigates the effects of government debt and deficits on long-term interest rates in 17 advanced economies over the period 1973–2016 from the perspective of currency sovereignty. The empirical findings of this paper suggest the market penalizes non-sovereign nations for the same amount of fiscal deficit with higher interest rates than sovereigns. In addition, non-sovereign countries face accelerating interest rates for an increase in the debt-to-GDP ratio beyond a certain threshold (49% to GDP) while such a pattern is not obvious among sovereign nations. Overall, the results support Modern Monetary Theory (MMT) view that a monetarily sovereign government, as a monopoly issuer of currency, can influence the prices of their liabilities to a significant extent, somewhat independent of existing public debt and market sentiment.

KEYWORDS:

• Sovereign currency
• government debt
• interest rate
• panel data
• Covid-19

JEL CLASSIFICATION:

• E42
• E43
• E58
• H6

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1. OECD (2020) predicted that the central government marketable debt-to-GDP ratio for the OECD area would rise by 13.4 percentage to around 86% in 2020.

2. Currency sovereignty will be discussed more in detail in the next section.

3. Wray (2006) meant exogeneity in the ‘control’ sense in that the government can ‘control’ the variables such as the money supply, the interest rate, the price level, and so on. It implies that that a central bank can independently set (or administer) the target interest rate where it seems best for a domestic economy. Furthermore, accommodative policy of a sovereign central bank can exogenously affect medium and long-term market interest rates in a significant way, somewhat independent of existing public debt and market sentiment.

4. Most advanced economies, unlike emerging economies, have minimal or no foreign currency denominated public debt liabilities, which automatically satisfies the third qualification for a sovereign government. Thus, we do not discuss a case of the breach of the last qualification in this paper.

5. Nersisyan and Wray (2010) critiqued Reinhart and Rogoff’s monumental studies (2009, 2010) by arguing that they misplaced emphases on the size of the public debt and its (domestic or foreign) ownership to calculate default risk. Nersisyan and Wray advocated that the correct way to analyze government finances must start from currency sovereignty because no sovereign country has defaulted on their own currency debt in Reinhart and Rogoff’s sample. Japan, for example, has not defaulted despite its high debt to GDP ratio (230% in 2018) not because a majority of bonds are held by its citizen but because its debt is denominated in its own floating, nonconvertible currency and thus the central bank of Japan can always honor its liabilities by creating its currency. Second, Nersisyan and Wray (ibid.) found it problematic that Reinhart and Rogoff made an analogy between public debt and private debt. The main difference between the two is that the sovereign government always services debt liabilities insofar as they are willing, while the households or private firms have to earn money to make payments as they come due. Non-sovereign countries can be rightly compared to the private sector.

6. Exchange rates are important to sovereign countries as well, but they do not need to raise the policy interest rate in response to government deficits. The floating rate regime provides an additional degree of autonomy to monetary policy that is not available in a fixed exchange rate regime.

7. Jordà, Schularick, and Taylor consulted a broad range of sources, such as economic and financial history volumes and journal articles, and various publications of statistical offices and central banks. For more information about a source of each variable for a country, refer to their website: http://www.macrohistory.net/JST/JSTdocumentationR4.pdf.

8. It is noted that both the deficit and the debt are, in contrast to other studies, included in our baseline specification because the interaction between them is expected. Given the current stock of debt, including the deficit, for instance, may help control for the expected future path of the debt itself (Ardagna, Caselli, and Lane 2007).

9. We focus on nominal, not real interest rates because the former is generally the main policy instrument of the central bank and thus a proxy for monetary policy space. However, we also use real interest rates as an alternative left-hand side variable for a robustness test.

10. The author appreciates an anonymous reviewer for his or her comment on this.

11. Current account, exchange rate, broad money supply (M3), total return on equity, and systemic financial crises are retrieved from Jordà-Schularick-Taylor Macrohistory Database.

12. Non-outlier countries are additionally excluded from the sample one by one for re-estimation without a significant difference in estimation results. Estimation results that exclude non-outlier countries for robustness test are available from the author upon request.

13. Real long-term and short-term bond yields are calculated using Fisher’s formula.

14. The principle of ‘sound finance’ is the necessity of balanced budgets over some time period or over the course of a business cycle that must be applied to households, firms, and non-sovereign governments. It is irrelevant to sovereign nations, but wrongly, widely used by politicians to justify fiscal consolidation.