Superstars of macroeconomics
Irving Fisher, Yale
(1867-1947)
James Tobin, Yale
(1918-2002)
J. M. Keynes, Kings College
(1883-1946)
Robert Mundell, Columbia
(1932 - )
Milton Friedman, Chicago
(1912-2006)
Janet Yellen, the Fed
(1946 - )
1
1
Debts and Deficits
Last time:
-
Conceptual issues of debts and deficits
Deficits and slower growth of potential Y in the closed economy
Role of deficit spending in recessions, particularly in the liquidity
trap
Today:
-
To raise or lower G in recessions, Europe and US today?
The death spiral of debt and default
2
The
twoViews
faces of
and the
deficit dilemma
Two
ofsaving
the Great
Unraveling
(I):
Soft Landing
What are the effects 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. (neoclassical growth model)
Dilemma of the deficit: Should we raise G today or lower G?
4
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.
6
Stimulus v. balanced budget in 2012
- Balance budget in 4 years (EU style austerity)
- Stimulate to reach FE in 3 years (Krugman style
superstimulus)
- Assume that 50% of public dissaving is offset by private
saving.
7
Actual deficits: ½ trillion a year
2004
2006
2008
2010
2012
2014
2016
2018
2020
200
0
Deficit (billions of $)
-200
-400
-600
-800
-1,000
-1,200
-1,400
-1,600
Krugman Deficit
Balanced Budget Deficit
8
The long-term debt
Have higher debt-GDP ratio for long time
2004
2006
2008
2010
2012
2014
2016
2018
2020
2022
2024
2026
90
80
Debt-GDP (% of GDP)
70
60
50
40
30
20
10
0
Krugman Debt-GDP
Balanced Budget Debt/GDP
9
But the economy pays the price in high U
With fiscal austerity, have long period of stagnation.
2004
2006
2008
2010
2012
2014
2016
2018
2020
14
12
10
Percent
-
8
6
4
2
0
Krugman U rate
Balanced Budget U rate
10
Lower potential with stimulus
Slower growth in potential with stimulus because the debt causes
lower capital stock
2004
2009
2014
2019
2024
2029
2034
2039
2044
30,000
28,000
26,000
Potential GDP ($ billions)
24,000
22,000
20,000
18,000
16,000
14,000
12,000
10,000
Krugman Potential GDP
Balanced Budget Potential GDP
11
Cumulative Difference in GDP
Because of recession, balanced budget doesn’t make it up in a
generation, even without discounting.
2004
2009
2014
2019
2024
2029
2034
2039
2044
100%
90%
80%
Percent of GDP
70%
60%
50%
40%
30%
20%
10%
0%
Cumulative Diff Krugman-BalBud (% GDP)
12
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.
13
Economics of External Debts
American Econ Review, August 2011. Also see their
book, This Time is Different..
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.
17
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.
18
Reinhard and Rogoff, From Financial Crash to Debt Crisis, AER, 2011
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
REVIEW: Romer debt model
Basic ideas:
- This is the run on the bank as applied to countries.
- Basic idea is that have an instability because of the impact of
risk on country interest rates (rd = rw + σ).
- Two equilibria: good (full employment) and bad (default)
Assumptions:
- Government has debt of D and default probability π.
- Governments have a random tax revenue, T, with cdf F(T).
- Interest:
R  1  r  (1  r ) (1-  )  R(1-  ), where r = risk-free rate.
R  (R  R) / 
- When T < RD, the government defaults
REVIEW: Math of Romer model
- Investor equilibrium:
  (R  R) / R
- Government default occurs when T < RD, which has a
cdf (cumulative distribution function):
  F ( RD )
- We have two equilibrium equations in R and π.
π
(prob. of
default)
REVIEW: Three equilibria
1
Investors
Government
and taxes
0
R
R (interest factor)
Simplified Romer model
-
Investor equilibrium that R = (1+rd) determined by prob of default:
R  R / (1   )
-
Assume for simplicity that taxes (T) are known with certainty to be
T*. So government default occurs when T < RD:
  1, when T < RD
  0, when T > RD
-
We have two equilibrium equations in R and π.
24
π
(prob. of
default)
With adequate revenues,
likely to have good equil.
1
Investors
Government
and taxes
0
R
R (interest factor)
π
(prob. of
default)
1
With low revenues, multiple
equilibrium with bad outcome
Government
and taxes
0
R
Investors
R (interest factor)
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
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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.
Interest rates on sovereign debt
8
7
UK
Spain
5
4
3
2
1
0
What can the EU do?
1. Fiscal austerity, but with great economic cost.
2. Guarantee debts, but this involves north-south transfer.
3. ECB buy bad debt, but moral hazard and hidden
transfers.
4. Break up Eurozone, but this has untold economic perils.
[See discussion in earlier class.]
30
Does this apply to the US?
Country type 1: What is the historical frequency of foreign 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.
Country type 2: What is the historical frequency of foreign debt
crises for countries with flexible exchange rates and debts
denominated in their own currency? E.g., US.
Answer: I could not find one.
Why? Because country type 2 can print money ($). Problem is
inflation or hyperinflation, not debt crisis.
31
Final words
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.”