Nick Rowe asks a good question: if we took our models seriously, what would we expect the effects of threatened default to be on the larger economy? His answer is that expected default should work just like expected inflation, which means that if anything it should be favourable right now.I think this is wrong — but in an interesting way.
It’s true that, say, a 1 per cent possibility that your bond holdings will become worthless within a year is similar to the expectation that inflation will erode those bonds’ real value by 1 per cent over the next year. But inflation doesn’t just erode the value of bonds; it also erodes the value of cash. And that’s why expected inflation can help in a liquidity trap: it makes sitting on cash less attractive. The threat of default doesn’t do that. As far as I know, we’re not talking about a loss of confidence in pieces of paper bearing pictures of dead presidents. And that’s why the threat of default isn’t equivalent — and not expansionary.
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