Debts, Panics, and Depressions 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 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? 17 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. 19 Stimulus v. balanced budget - 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 21 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 24 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. 25 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!