High levels of public debt in some EC countries may make it impossible to reconcile free capital mobility after 1992 with stable exchange rates in the EMS, unless appropriate debt management policies are introduced, Marco Pagano told a lunchtime meeting on 31 October. Pagano is Associate Professor of Economics at the Università di Napoli and a Research Fellow in CEPR's International Macroeconomics programme. He has written a chapter on public debt management in High Public Debt: The Italian Experience (Francesco Giavazzi and Luigi Spaventa (eds.), Cambridge University Press for CEPR, 1988) and several CEPR Discussion Papers. The research on which Pagano's talk was based was carried out as part of a research programme on `Macroeconomic Interactions and Policy Design in Interdependent Economies', with financial support from the Ford Foundation and the Alfred P Sloan Foundation. The opinions he expressed were his own, however, and not those of the Ford or Sloan Foundations or of CEPR, which takes no institutional policy positions.

By 1992 members of the European Community will have to remove all remaining barriers to the free movement of capital. At the same time, EMS arrangements are likely to evolve towards even greater exchange rate stability. Thus Europe is engaged in creating an area of quasi-fixed exchange rates with no capital controls. Persistent differences in rates of inflation will still require periodic adjustments of EMS parities to prevent excessive deviations of real exchange rates from their equilibrium values. To date, these adjustments have been carried out relatively smoothly, partly because until recently capital controls had largely been retained in most countries where inflation is above the European average.
If capital controls are completely removed while inflation differentials persist, the danger is clear: when investors expect devaluation of a `soft' currency, they will launch a speculative attack on the foreign exchange reserves of that country and may force it to devalue, against the wishes of its Central Bank. This would render the monetary authorities incapable of deciding the timing of EMS realignments, and would expose the System to repeated speculative attacks and forced devaluations.
Italy, Belgium, Spain, Portugal and Greece have so far experienced inflation above the EC average. If some of these countries succeed in reducing their actual and expected inflation rates to the EC average, then there should be no reason for currency speculators to expect these countries to devalue the `fundamentals' of monetary policy would be consistent with a fixed EMS parity. Unfortunately, Pagano argued, things are not so simple. Even if it is not based on `fundamentals', a speculative attack could still be successful in a high-debt country if the public debt were inappropriately managed. All these five countries are characterized by relatively high debt/ income ratios, high recourse to Central Bank loans by the Treasury, and relatively short debt maturity. Pagano's research with CEPR Programme Director Francesco Giavazzi led him to conclude that this combination would render the currencies of these countries particularly vulnerable to speculative attacks, even if the attacks were not justified by monetary fundamentals.
With a fixed exchange rate but without capital controls the monetary authorities must surrender control over domestic interest rates. If the Central Bank tried to control interest rates it would be unable to defend its exchange rate when faced by a run on its foreign exchange reserves. If speculators are convinced that a devaluation will occur, domestic rates must rise, whether or not the Central Bank is really planning a devaluation. Pagano referred to such a change in expectations as a `confidence crisis'.
For the Central Bank, an effective response to a confidence crisis may be to allow the interest rate to rise. For the Treasury, however, an interest rate rise may be a disaster if it coincides with the expiry of a large amount of public debt that needs to be reissued. To avoid reissuing the debt at punitive rates, the Treasury will turn to the Central Bank for a loan until interest rates fall from their abnormal levels. Even if the loan to the Treasury is to be repaid after the crisis subsides, so that both current and expected inflation do not change throughout, the resulting injection of liquidity will fuel the speculation against the Central Bank and make devaluation more likely than it would otherwise be.
Giavazzi and Pagano's research suggested that this conflict between the Central Bank and the Treasury is more serious in countries where public debt is high and concentrated at short maturities, where large quantities of debt expire at the same time and where the Treasury is allowed substantial recourse to Central Bank loans. Conversely, the probability that a confidence crisis will lead to devaluation can be lessened by reducing the debt to be issued by the Treasury at each date on the domestic market. Pagano therefore proposed three rules to reduce the conflict between defence of the exchange rate and public debt management:
lengthen the average maturity of public debt;
smooth out the time pattern of maturing debt;
develop a well-functioning market for foreign currency debt, to which the Treasury can turn for finance if need be.
These policies can be implemented in time for 1992, provided they are rapidly adopted. For Italy, Belgium and Spain the adoption of these rules would require drastic reversal of current debt management policies. The Italian situation Pagano described as particularly ominous: large quantities of public debt will mature in 1990 and 1991 just as capital market liberalization gathers force. Portugal and Greece already have a substantial proportion of their public debt denominated in foreign currency, but they still have a large proportion of short-term debt. Ireland is a conspicuous exception: despite its very high and rapidly growing debt/GDP ratio, its debt management policy is already largely in line with Pagano's three policy prescriptions.
One member of the audience asked whether the proposal to increase debt denominated in foreign currency was to reduce long-run vulnerability to a confidence crisis, or to allow recourse in a crisis to finance from foreign debt. Pagano argued that both were useful, though recourse to foreign currency borrowing bore the risk that it would have to be paid back with a devalued domestic currency. The main point of this facility was to prevent a devaluation. It was also remarked that increasing the average maturity of debt would have the cost of increasing the interest paid on all the other debt.