Quantitative Easing and Government Debt Sustainability

Abstract

We show how quantitative easing (QE) can lower government borrowing rates while weakening long-run debt sustainability. In a model with downward-sloping debt demand and primary deficits, we establish a trilemma: central bank purchases cannot simultaneously lower rates, leave the primary balance unchanged, and preserve central bank capital—the finite resources underpinning the central bank’s power to lower borrowing rates and provide crisis financing. QE depletes central bank capital, reducing future fiscal income and crisis-financing resources. This depletion raises stable steady-state debt and lowers the default boundary. Sufficient central bank capital depletion can eliminate the stable steady state and eventually lead to government default. Moreover, continued QE to keep borrowing rates low requires accelerating central bank capital depletion, but rapid quantitative tightening (QT) to rebuild central bank capital can raise borrowing rates above their pre-QE level, producing a taper-tantrum-like spike. Longer QE magnifies this QT spike and can destabilize debt, creating an intervention trap that requires renewed central bank intervention or fiscal adjustment. Joint paper with Wenhao Li.