Debts, Panics,
and Depressions
Debts and Deficits
Last time:
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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:
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The death spiral of debt and default
Keynes and the classical economist on deficit financing
2
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]
3
American Econ Review, August 2011.
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.
5
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.
6
Reinhard and Rogoff, From Financial Crash to Debt Crisis, AER, 2011
Country crises as bank runs
Problem with financial crisis is that have an additional risk element, where
r
risky
 risk-free interest rate  risk premium = i  
where  = risk premium on country debt = risk of default. New stable d ebt is
  / t   0  ( i    g )  PS /Y
So again assuming that i  g, now PS must be higher for sustainability:
PS / D  
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.
8
Country fiscal
position
Fiscal deficits plus loss of
confidence pushes over
the tipping point to where
cannot refinance debts
Rising risk premium and interest burden
Unstable equilibrium
Debt-GDP ratio =   D / Y .
 /   rate of change of   ( i    g)  PS / D.
 is a rising function of debt,  (  ).
Assume that countries run a small surplus in normal times
when   0:
( i  g )  PS / D  a.
Then have a stable and an unstable equilibrium, and a
bad shock sends countries into default.
10
Unstable equilibrium
( )
 (  ),  / 
a
Unstable equilibrium,
tipping point
Debt-GDP ratio (β)
11
EZ interest rates
Examples of unstable equilibria
2012-10-01
2012-07-01
2012-04-01
2012-01-01
2011-10-01
2011-07-01
2011-04-01
2011-01-01
2010-10-01
2010-07-01
2010-04-01
2010-01-01
2009-10-01
2009-07-01
6
2009-04-01
2009-01-01
2008-10-01
2008-07-01
2008-04-01
2008-01-01
2007-10-01
2007-07-01
2007-04-01
2007-01-01
The unfortunate weak currencies in the EZ
Spain and UK had virtually same deficit and fiscal position in 2010.
8
7
UK
Spain
5
4
3
2
1
0
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.
15
The final issue of Keynesian debt dynamics
Two Views of the Great Unraveling (I):
The two faces of Soft
saving
and the deficit dilemma
Landing
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?
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Impact of fiscal stimulus
AS’
AS
Inflation
?
AD’
AD
Real output (Y)
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.
1. Demand for goods and services: yt   rtb   * Gt   t
2. Business real interest rate:
rtb  it –  te   t  rt   t
3. Phillips curve:
 t   te   yt  t
4. Inflation expectations:
5. Monetary policy:
 te   t 1
i t   t  r *   ( t  *)  Y yt
6. Potential output:
Yt pot  At F [ K t , LFt (1  u*)]
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.
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Stimulus v. balanced budget
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Balance FE budget in 4 years
Stimulate enough to get to FE in 3 years
Size of stimulus, two runs (billions)
1,000
900
800
700
600
500
Balanced FE budget
400
Big stimulus
300
200
100
0
2011
2016
20
Actual deficits
-
Actual deficit is still large because of recession.
Federal deficits, two runs (billions)
1,400
1,200
1,000
800
600
400
Balanced FE budget
200
Big stimulus
0
2003
2008
2013
2018
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The long-term debt
Have higher debt-GDP ratio for long time
Debt-GDP ratios:
fiscal stimulus v balanced budget
1.20
1.00
0.80
0.60
0.40
Big stimulus
0.20
Balanced FE budget
0.00
2010
2015
2020
2025
22
But the economy pays the price
-
With fiscal austerity, have long period of stagnation.
Actual /potential output, two runs
1.10
Balanced FE budget
1.05
Big stimulus
1.00
0.95
0.90
0.85
0.80
2003
2008
2013
2018
2023
23
The dilemma of the deficit
Slower growth in potential with stimulus, but it doesn’t make up the
difference.
Potential output, two runs (billions)
21,000
20,000
Balanced FE budget
Big stimulus
19,000
18,000
17,000
16,000
15,000
14,000
13,000
2007
2012
2017
2022
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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.
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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!