Debts, Panics, and Depressions

2

Debts and DeficitsLast 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

3

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.

5

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.

6

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

8

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

10

Unstable equilibrium

Debt-GDP ratio = / ./ rate of change of ( ) / .

is a rising function of debt, ( ).Assume that countries run a small surplus in normal timeswhen 0:

( ) / .Then have a stable and

D Yi g PS D

i g PS D a

an unstable equilibrium, and abad shock sends countries into default.

Unstable equilibrium

11

( )

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

15

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

17

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 stimulus

AS

AD’

?

19

The dilemma of the deficitTo 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 Gr 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

20

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

21

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

22

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

23

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

24

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

25

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 macroeconomicsYou 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!

.