Study of Economic Stability for handling Risky Debts, Diabolic Loop, Stability and Dominance

For understanding the Great Recession, Inter-relationship among Financial Stability, Price Stability and Debt Sustainability Concepts are essential.

This is the final part of our article series about the Diabolic System of Money in Banking. In part one, you have learned How banks create money, In part two, exploring about, How Adverse shock is amplified through the liquidity and disinflation spiral. Then part three, have explained, How re-distributive monetary policy can mitigate these adverse spirals by affecting asset crisis. Now, in part four, we'll study economic stability in a world in which the government might default on its debt.
#Risky Government Debt, Diabolic Loop, Stability and Dominance Concepts


We introduce three Concepts, the Diabolic Loop, Doom loop, and Dominance Concepts. Finally, we will put everything together to get a full picture of the analysis.

Economic Stability can be broken up in three different stability concepts:
1- Financial Stability, The absence of a financial crisis in the financial sector.
2- Price Stability, the absence of very high inflation or deflation, and fiscal.
3- Debt Sustainability, the absence of any default risk in government debt. That is the government honors its debt.

Prior to the Great Recession, Policymakers thought it would be best to assign a separate authority to each stability concept. This assumed that one can read all stability concepts separately isolated from each other.

The three authorities are Fiscal authorities, the Central bank, and Financial regulators. How would you assign these authorities? With fiscal authority? It's obvious that it is the government's job to pay back its debt. The central bank is a little trickier to place Central Bank in charge of PI's or financial stability. Initially, central banks were found it will take care of financial stability. But starting in the 1980s, the central banks became more and more focused on price stability and financial regulators would be in charge of financial stability.


Let's re-arrange things, in form of a above matrix chart. We will return to this matrix again and again. That diagonal elements stress the clear assignment of tasks, while the off-diagonal elements stress interaction between the stability concepts. In part two, we have seen the close interaction between financial stability and price stability. After an adverse shock, and the capitalized banks shrink the balance sheets causing disinflationary pressure and interest rate cut liens against it. It increases the value of long-dated assets like government bonds and thereby recapitalize the banks.

But what happens if the government debt is not sustainable, and the government might not own its debt? We have to generalize our framework a bit. We now depart from the assumption that government debt is always safe. Let's introduce the fear that government bonds might default. Looking at the balance sheet of the government, you can see that the government's long term bonds are on the liability side. The present value of all future taxes minus expenditures counterbalance these liabilities.

With a negative shock, government tax revenues go down. If government expenditures don't follow, and also decline, investors might be unsure whether the government is able to honor its debt obligations. It is useful to distinguish between three forms of dominance, Fiscal Dominance, Monetary Dominance, and Financial Dominance.

Fiscal dominance refers to the unwillingness of the government to balance its long-run budget. One way out is to print more money to balance a budget through inflation. But under monetary dominance, the central bank is unwilling to print more money to balance the budget. Fiscal authorities, that is the government and monetary authorities central bank play a game of chicken. If both fiscal authorities and the central bank insist on the dominance that default of government debt cannot be ruled out. If for example, part of the debt is inflation-indexed foreign currency-denominated what the company is a member of a currency union.

 The question then arises with the banking sector which holds some of the long term bonds that have enough equity such that it is able to absorb losses that arise from the default of the government bonds. Under the third concept, financial dominance, banks are unwilling to raise equity or deliberately undercapitalized, the fear that otherwise losses will be pushed onto them. If banks are undercapitalized, a default of government bonds would cause large contagion and ripple effects to the real economy. Let's return to our matrix chart, which highlights the three stability concepts, and there are three authorities we are now able to put all the pieces together.

Previously, we have looked at how an adverse shock to end progress triggered an initial decline in bank assets. This led to a decline in equity and banks extended less credit and engaged in file sales of assets which Further decreased asset values and equity. The liquidity spiral caused financial instability also, as banks engaged in final sales of assets and trying to balance sheets, the ends add money on the liability side found this lower total money supply in the economy. In addition, as banks diversify less idiosyncratic risk, individuals want to hold more cash, which increases money demand.

Both the decline in money supply and the increase in money demand causes disinflationary pressures. And as the value of money increased through this inflation, the bank's liabilities increased, and the equity shrank even further, banks responded by reducing their credit supply to the real economy. This will reduce overall economic activity. GDP went down and then the government lost tax revenue. All of this made the long term government bond more riskier.

Now coming back to dominance and fiscal dominance, the government is reluctant to reduce long term expenditures or raise taxes. Under monetary dominance, the central bank is reluctant to put in additional money to create SR rich for financing government expenditures. If neither party gives up in this game of chicken represent our job by a line going through both fiscal and monetary dominance boxes.

The default risk in particular when part of the debt is inflation-indexed goes up. This lowers the value of the long term government bonds. So now, unlike before, the initial adverse shock to banks assets translate into an additional shock to the long term government bond losses are not offset by capital gains or long term government bonds, but amplified by additional losses under financial dominance, Banks don't place new equity, but rather cut the credit supply, with less credit going to the real economy at diabolic spiral between the financial sector risk and the government bond default risk emerges.

Both banks and the government become riskier and feed on each other, leading to a higher risk premium. Of course, the central bank could have given up its monetary dominance and agreed to print more money. Graphically, this is represented by a line by pausing the monetary but not the fiscal dominance box. This turns off the diabolic loop, but leads to an inflationary force, especially when structural reforms are needed. Because the economy was hit by a permanent shock.

This inflationary force could counterbalance a disinflationary force coming from the debt disinflationary spiral Which in turn comes from the interaction between price and financial stability. So essentially you have two forces, a disinflationary one, and an inflationary one pushing in different directions. However, these two forces are difficult to balance in crisis times.

The system is very unforgiving of small mistakes in our crisis. It is like riding a bike. When the economy grows, balancing these two forces. One disinflationary and one inflationary is not very difficult, just like riding a bike at a reasonable speed. But if the economy slows down, just like a bike slows down, it becomes increasingly difficult to balance both forces, just as it is hard to predict where the bike might fall on one side or the other. So it is difficult to predict when the economy will drift off the deflationary or the inflationary side.

This might explain why inflation expectations are so different in times of crisis. Some people emphasize inflation, while others fear disinflation. Ideally, one would never like to get even close to situations in which all three of the spirals are active. The best monetary policy is preventive monetary policy.

Hence, the optimal policy is forward-looking and includes early warning signals. It is important to follow credit growth to see where the imbalances are building up in the financial sector. In addition to the non-financial corporate sector, as was the case in Japan in the 1980s, or in the housing sector, as was the case in the United States in the 2000s.

Credit and monetary quantities can point out where imbalances are building up. imbalances are likely to emerge when volatility is low since people will take on more leverage and when There are many financial innovations quantity constraints like a loan to value ratios and debt to income ratios. In addition to other macro Prudential tools are important to ensure that the three spirals outlined in this lecture are not driving an economy into the ground.

Let me conclude. Firstly, I've seen that liquidity spirals amplify initial shocks, systemic risk arises a risk that is endogenously generated by the system itself. Second, financial instability spills over the price instability through the disinflationary spiral. disinflation, in turn, wasn't financial stability.

To limit systemic risk. Monetary Policy takes on a redistributive role within monetary policy, we contrasted the money view with the credit view the form of focuses on monetary aggregates on the liability side of the bank's balance sheets, the latter on credit aggregates on the bank's asset side.

Fiscal debt sustainability issues arise when there is a fear that the government cannot honor its own debt obligations. The diabolic spiral or loop emerges. An increase in bank risk also increases the risk of government debt and vice versa.

Under such circumstances, central banks might have a difficult time balancing the strong inflationary and disinflationary forces in some good economic policies. Take these interactions into account, but importantly, are forward-looking in order to stay away from the strong interactive forces. That link is three stability concepts, financial support price stability, and fiscal debt sustainability.

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Beyond Narrative | Blog Where Every Single Word Matters: Study of Economic Stability for handling Risky Debts, Diabolic Loop, Stability and Dominance
Study of Economic Stability for handling Risky Debts, Diabolic Loop, Stability and Dominance
For understanding the Great Recession, Inter-relationship among Financial Stability, Price Stability and Debt Sustainability Concepts are essential.
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