debts, panics, and depressions. debts and deficits last time: -conceptual issues of debts and...
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Debts, Panics, and Depressions
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Debts and Deficits
Last time:- Conceptual issues of debts and deficits- Deficits and slower growth of potential Y in the closed
economy- Deficits and foreign borrowing and lower national income
(Y+net foreign earnings) in the open economy
- Fiscal cliff
Today:- The death spiral of debt and default- Keynes and the classical economist on deficit financing
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Debt and financial crises
“Political incentives for additional borrowing could change quickly if financial markets began to penalize the United States for failing to put its fiscal house in order.
If investors become less certain of full repayment or believe that the country is pursuing an inflationary course that would allow it to repay the debt with devalued dollars, they could begin to charge a “risk premium” on U.S. Treasury securities. That could happen suddenly in a confidence crisis and ensuing financial shock.
There is precedent for a financial disruption first contributing to large, chronic deficits and then in some cases contributing to the loss of investor confidence and even to a default on a nation’s debt.
[However,] the unique position of the United States—because of its economic dominance and the dominant role of the dollar internationally—make it difficult to extrapolate from the experience of other nations in estimating the risk or timing of a financial crisis arising from failure to address the projected U.S. fiscal imbalance.
[National Academy of Sciences panel, Choosing the Nation’s Fiscal Future, 2009]
American Econ Review, August 2011.
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Misinterpretation by Deficit Commissioner
“When the markets lose confidence in a country, they act swiftly and they act decisively. Look at Greece, look at Portugal, look at Ireland, look at Spain.* If they markets lose confidence in this country and we continue to build up these enormous deficits and debt, they will act swiftly and decisively.”
[Erskine Bowles, Chair, President’s Commission]
* BTW: This is completely wrong analytically.
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Defaults and restructuring are endemic
• Default: A sovereign default is defined as the failure to meet a principal or interest payment on the due date (or within the specified grace period).
• These are often called “restructuring” or “repudiation” but have the same effect.
Reinhard and Rogoff, From Financial Crash to Debt Crisis, AER, 2011
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Country crises as bank runs
Problem arises because have an unstable equilibrium where country’s liquid liabilities >> its liquid assets.
A higher debt → higher probability of default (σ)→ higher rrisky → requires more budget cuts and less likely to pay → higher σ → eventually the country decides to default or restructure.
Examples:• Greece β=1.4. If markets put σ =5%, primary surplus ratio must be
7% of GDP. If Greeks start revolting, σ =10%, then required surplus goes to 14% of GDP. So have a good and bad equilibrium like bank runs.
Problem with financial crisis is that have an additional risk element, where
risk-free interest rate risk premium =
where = risk premium on country debt = risk of default. New stable d
riskyr i
ebt is
/ 0 ( ) /
So again assuming that , now PS must be higher for sustainability:
/
t i g PS Y
i g
PS D
Fiscal deficits plus loss of confidence pushes over the tipping point to where cannot refinance debts
Country fiscalposition
Rising risk premium and interest burden
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Unstable equilibrium
Debt-GDP ratio = / .
/ rate of change of ( ) / .
is a rising function of debt, ( ).
Assume that countries run a small surplus in normal times
when 0:
( ) / .
Then have a stable and
D Y
i g PS D
i g PS D a
an unstable equilibrium, and a
bad shock sends countries into default.
Unstable equilibrium
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( )
aUnstable equilibrium, tipping point
Debt-GDP ratio (β)
( ), /
EZ interest rates
Examples of unstable equilibria
The unfortunate weak currencies in the EZ
Spain and UK had virtually same deficit and fiscal position in 2010.
0
1
2
3
4
5
6
7
820
07-0
1-01
2007
-04-
01
2007
-07-
01
2007
-10-
01
2008
-01-
01
2008
-04-
01
2008
-07-
01
2008
-10-
01
2009
-01-
01
2009
-04-
01
2009
-07-
01
2009
-10-
01
2010
-01-
01
2010
-04-
01
2010
-07-
01
2010
-10-
01
2011
-01-
01
2011
-04-
01
2011
-07-
01
2011
-10-
01
2012
-01-
01
2012
-04-
01
2012
-07-
01
2012
-10-
01
UK
Spain
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Does this apply to the US?
Question: What is the historical frequency of debt crises for countries with either fixed exchange rates or debts denominated in external currencies a la Greece, Italy, Spain, Argentina, etc.?
Answer: average of 14 every year for last two centuries.
Question: How many countries with flexible exchange rates and debts denominated in their own currency have had a foreign exchange crisis?
Answer: I could not find one.
Two Views of the Great Unraveling (I):Soft Landing
The final issue of Keynesian debt dynamics
The two faces of saving and the deficit dilemma
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What is the effect of deficit reduction on the economy?
1. In short run: • Higher savings is contractionary • Mechanism: higher S, lower AD, lower Y (straight
Keynesian effect)
2. In long-run:• Higher savings leads to higher potential output • Mechanism: higher I, K, Y, w, etc. (through neoclassical
growth model)
Dilemma of the deficit: Should we raise G today or lower G?
Real output (Y)
Inflation
AD
AS’
Impact of fiscal stimulusAS
AD’
?
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The dilemma of the deficit
To illustrate, I use a little simulation model built from our five equation IS-MP model plus a Solow growth model.
Then compare (1) a large stimulus program to reach full employment(2) a balanced budget program
Use historical data, calibrated model, and “plausible” projections of variables.
1. Demand for goods and services: *
2. Business real interest rate: –
3. Phillips curve:
4
bt
b et t
et
t t t
t t t t
t t t
y r G
r i r
y
1
. Inflation expectations:
5. Monetary policy: * *
6. Potential output:
(
[
)
, (
et
pott
t
t t t Y t
t t t
i r y
Y A F K LF
1 *)]u
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Stimulus v. balanced budget- Balance FE budget in 4 years- Stimulate enough to get to FE in 3 years
0
100
200
300
400
500
600
700
800
900
1,000
2011 2016
Size of stimulus, two runs (billions)
Balanced FE budget
Big stimulus
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Actual deficits- Actual deficit is still large because of recession.
0
200
400
600
800
1,000
1,200
1,400
2003 2008 2013 2018
Federal deficits, two runs (billions)
Balanced FE budget
Big stimulus
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The long-term debtHave higher debt-GDP ratio for long time
0.00
0.20
0.40
0.60
0.80
1.00
1.20
2010 2015 2020 2025
Debt-GDP ratios:fiscal stimulus v balanced budget
Big stimulus
Balanced FE budget
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But the economy pays the price- With fiscal austerity, have long period of stagnation.
0.80
0.85
0.90
0.95
1.00
1.05
1.10
2003 2008 2013 2018 2023
Actual /potential output, two runs
Balanced FE budget
Big stimulus
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The dilemma of the deficitSlower growth in potential with stimulus, but it doesn’t make
up the difference.
13,000
14,000
15,000
16,000
17,000
18,000
19,000
20,000
21,000
2007 2012 2017 2022
Potential output, two runs (billions)
Balanced FE budget Big stimulus
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Conclusions on Debt and Deficits
• Central long-run impact of fiscal policy is on POTENTIAL output through impact on national savings rate.
• But in deep recessions, particularly in liquidity trap, need larger deficits to stimulate ACTUAL output reach full employment.
• So policy needs differ in recession and full employment.
Final word on macroeconomics
You have heard of the “hard sciences.” But macro is a “very hard science.” Why is it so challenging? Listen to the conversation between Keynes and the revolutionary physicist, Max Planck, that took place at high table in King’s College, Cambridge:
“Professor Planck, of Berlin, the famous originator of the Quantum Theory, once remarked to me that in early life he had thought of studying economics, but had found it too difficult! Professor Planck could easily master the whole corpus of mathematical economics in a few days. But the amalgam of logic and intuition and the wide knowledge of facts which is required for economic interpretation in its highest form is overwhelmingly difficult.”
So now it is in your hands!
.