DP11834 Central Bank Policies and the Debt Trap
Monetary policy and fiscal dynamics are inexorably linked. When a government faces the risk of getting caught in a high debt trap, debt monetization may become an appealing option. However, independent central banks may be able to allay debt concerns without compromising price stability. One option is financial repression which, despite associated distortions, can create some fiscal space while preserving price stability. Financial repression is a feature of quantitative easing, which has proven to be an effective policy tool at the zero lower bound. This paper examines the policies of the Federal Reserve, the Bank of Japan and the ECB in relation to debt dynamics for the United States, Japan, Germany and Italy since the crisis. Important differences are identified across the four states, reflecting differences in the policy choices of the three central banks. While decisive QE policies by the Federal Reserve and, more recently, by the Bank of Japan have been effective, ECB policies have had decidedly uneven consequences on Germany and Italy. The normalization of the Federal Reserve’s balance sheet is also discussed in a historical context.