debt, debt crises, politics, and currency unions - unich.it · 04/07/2012 1 debt, debt crises,...

04/07/2012

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Debt, Debt Crises, Politics, and Currency Unions

Ugo Panizza

UNCTAD & The Graduate Institute, Geneva

These are my own views

The Euro: manage it or leave it!

Gabriele d'Annunzio University, June 23

d'Annunzio and economics

The tenth Corporation envisioned in the Charter of Carnaro (Fiume, 1919) had solved the economic problem:

“The tenth corporation is reserved for the mysterious forces of progress and adventure. .. to the man of the future, to the hoped-for idealization of daily work, to the liberation of the spirit of man beyond the panting effort and bloody sweat of today.

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d'Annunzio and debts

• In 1909, creditors foreclosed 47 boxes of books and manuscripts

• Giovanni Pascoli offered to bail him out with a poem titled "La catastrofe"

• In 1910, d'Annunzio escapes to France in order to avoid paying its debts

Outline

• Debt and politics in tranquil times

• Debt and politics during crises– When defaults cannot be avoided

– When defaults can be avoided

• The politics of the resolution of sovereign defaults

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Debt and Politics in Tranquil Times

• Politics and deficit (debt) bias– Because of excessive optimism

• Not enough savings in good times– Remember the official reason for Greenspan’s support of

tax cuts during the Bush administration

– Because issuing debt allows to postpone difficult decisions

– Because of strategic considerations• Why would Ronald Reagan run a large budget

deficit?

Solutions

• Budgetary institutions– Smart budgetary rules

– Transparency rules

– Hierarchical rules

• Like motherhood and apple pie, these are great things…

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…but they may not be enough

• The relationship between deficit and debt is not as tight as you may think

• Low debt is not enough

How Debt Grows?

• The economics 101 debt accumulation equation states that: – CHANGE IN DEBT = DEFICIT

• Practitioners use: – CHANGE IN DEBT = DEFICIT+SF– SF=Stock-flow reconciliation, or the unexplained part

of public debt

• The stock-flow reconciliation is often considered a residual entity of small importance

• Is it?

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5

00.050.1

0.150.2

0.250.3

0.350.4

0.450.5

0.55

AllCountries

SSA LAC SAS EAP MNA ECA IND

If we estimate: titiiti dD ,,,

Source: Campos, Jaimovich and Panizza (2006)

We expect: and R2 to be close to 1 and = 0

R-Squared

The Unexplained Part of Public Debt

0

1

2

3

4

5

6

7

Stoc

k-fl

ow r

econ

cili

atio

n %

of

GD

P

IND MNA EAP ECA LAC SSA


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• The growth rate of the debt-to-GDP ratio is equal to:– Primary deficit/GDP + interest payments/GDP+

– GDP growth – inflation• The last two variables are multiplied by the debt-to-

GDP ratio

• If you like math:

t

t

t

t

t

t

t

t

t

t

t

t

Y

SF

Y

Dg

Y

Di

Y

PD

Y

D

Y

D

Y

D

11

1

1 )(


-15

-10

-5

0

5

10

15

IND SAS CAR EAP ECA MNA LAC SSA

INFLATIONGDP GROWTHUNEXPLAINED PARTINTEREST EXPENDITUREPRIMARY DEFICIT


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• What explains the “Unexplained” part of debt– Skeletons

• Fiscal policy matters!• Transparent fiscal accounts are important

– Banking Crises– Balance Sheet Effects due to debt

composition• In the presence of foreign currency debt, currency

devaluations lead to sudden debt explosions

Example: ArgentinaArgentina: Federal Govt. Balance over GDP

-4

-3

-2

-1

0

1

2

3

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

FG

bal

ance

ove

r G

DP

(%

)

1991-2000 average: -1.2% of GDP

Source: JP Morgan (post 1998) and ECLAC (pre 1998)

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Argentina: Public Debt/GDP

0

20

40

60

80

100

120

140

160

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Deb

t o

ver

GD

P (

%)

Cumulative deficit over 2000-2002: 5.4% of GDP (3% in 2001 and 2.4% in 2002)

Change in the debt to GDP ratio between 2001 and 2002: 98% of GDP

Source: JP Morgan (post 1998) and CLYPS

INAFIt's Not Always Fiscal

From:

It's Mostly Fiscal

to:

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… but they may not be enough

• The relationship between deficit and debt is not as tight as you may think

• Low debt is not enough– Example: UK versus Spain

– (with thanks to Paul De Grauwe)

Debt …Total Gross Public Debt/GDP

(Spain versus UK)

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

100.0

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Deb

t/G

DP

(%

)

Spain United KingdomSource: Eurostat

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…and yields10Yr Govt. Bond Yields

(Spain versus UK)

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Jan‐06

Mar‐06

May‐06

Jul‐06

Sep‐06

Nov‐06

Jan‐07

Mar‐07

May‐07

Jul‐07

Sep‐07

Nov‐07

Jan‐08

Mar‐08

May‐08

Jul‐08

Sep‐08

Nov‐08

Jan‐09

Mar‐09

May‐09

Jul‐09

Sep‐09

Nov‐09

Jan‐10

Mar‐10

May‐10

Jul‐10

Sep‐10

Nov‐10

Jan‐11

Mar‐11

May‐11

Jul‐11

Sep‐11

Nov‐11

Jan‐12

Mar‐12

May‐12

(%)

Spain United KingdomSource: Bloomberg

What really went wrong in EuropeInflation1) Divergence in EMU

95

100

105

110

115

120

125

130

135

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Years

Ind

ex

19

99

= 1

00

Southern Europe

ECB‘s Inflation Target

France

Germany

EMU

Inflation=GDP deflator 1999 = 100; SE=Greece, Italy, Portugal, and Spain; ECB IT= 2%; EMU=EMU12 average

Source: Heiner Flassbeck

Inflation Divergence in EMU

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What really went wrong in Europe

Unit Labour1) Costs in Germany, France, and Southern Europe

95

100

105

110

115

120

125

130

135

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Years

Ind

ex

19

99

= 1

00

Southern Europe

Germany

France

ECB‘s IT

Unit Labor Costs

Source: Heiner Flassbeck

Outline





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The politics of sovereign default

• Policymakers (domestic and international) have strong incentives to gamble for redemption and delay the moment of reckoning

• Borensztein and Panizza (2009), Levy Yeyati and Panizza (2010)

– The problem historically has not been that countries have been too eager to renege on their financial obligations, but often too reluctant.

• Memo prepared by the Central Banks of England and Canada (Source: Bluestein, 2005, p 102)

• And this is bad because it prolongs the economic crisis and reduces recovery value– For both economic and political reasons

• Everybody is worse off

Outline





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The politics of crisis packages

• Packages often come with:– Requests for fiscal consolidation

– Not “too much” money

– Interest rates which are above the opportunity cost of funds

• Does this approach make sense from an economic point of view?

• I will argue that it does not

Fiscal consolidation• Rationale (1)

– They need to put their house in order

• But…– Was the crisis caused by fiscal misbehavior?

• We saw that in many cases, fiscal policy was not the problem

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Fiscal consolidation

• Standard answer:– Yes, but now the debt is high and things have

changed!– Think about the math:

d=-ps+(i-g)d• Assume LT growth 2% and LT interest rate 3%. Then, if debt

increases by 50% of GDP, ps needs to increase by 0.5% of GDP

– Also, multiple equilibria (high i and low i)• Should "bailouts" have punitive interest rates?

– More on this in a minute

Fiscal consolidation• Moreover

– Even when the source of the problem was fiscal misbehavior, sustainable fiscal policy is a long-term concept

– Short-term restrictive policies may be counterproductive because

• They may worsen the crisis

• They may be reversed as soon as the situation improves and the country no longer needs international assistance

– Success requires addressing the political distortions that led to the unsustainable long-term policy stance

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Source: Martner and Tromben (2005)

When growth-promoting spending is cut so much that the present value of future government revenues falls by more than the immediate improvement in the cash deficit, fiscal adjustment becomes like walking up the down escalator.

(Easterly, Irwin, Serven, 2008)

…and this may be bad for growth, and for the fiscal adjustment

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Fiscal consolidation

• Rationale (2)– High public debt is bad for growth

• But…– No evidence on the causal effect of public

debt on growth

The correlation between public debt and growth

Source: Panizza and Presbitero (2012)

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The causal effect of public debt on growth

Source: Panizza and Presbitero (2012)

Interest rates above opportunity cost and not “too much” money

• Rationale (1)– Need to protect our own taxpayers

• But… – The smaller the size of the package and the

higher the interest rate, the less likely the success of the package

• (higher risk for the taxpayer)

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Interest rates above opportunity cost and not “too much” money

• Rationale (2)– Avoid moral hazard

• But…– Do you really believe that politicians are so

farsighted?

– Bagehot was right for banking crises, but he may be wrong for sovereign debt crises

– Moral hazard is often overstated (Meltzer versusKrugman)

Why do we observe actions that go against economic logic?

• Wrong economic model– Some countries and economists still live in the

shadow of the Treasury view

• Politics– In this case, not politics in the crisis country,

but politics in the “strong” countries

– Electors want a pound of flesh

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Outline





Problems with the current non-system for the resolution of sovereign debt crises

• Debt renegotiations take too long, their outcome is uncertain and, in general, they do not restore debt sustainability

• Creditors' coordination and the holdout problem

• Lack of private interim financing

• Overborrowing caused by debt dilution

• Delayed defaults

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The costs of defaults are hard to find:Reputation

-100

0

100

200

300

400

500

600

700

1 2 3 4

Years after the default episode

So

vere

ing

Sp

read

(b

asis

po

ints

)

• 3 years after the resolution of a default episode, there is no statistically significant difference between the spreads paid by defaulters and non defaulters• We find similar results if we look at access• Global factors (risk aversion and US interest rate) appear to be more important than default history

Source: Borensztein and Panizza (2009)

The costs of defaults are hard to find:GDP growth

Source: Levy Yeyati and Panizza (2010)

85

90

95

100

105

110

115

-12 -8 -4 0 4 8 12

Event time

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Why delayed defaults?

• Two possible stories

• Bad politicians– Defaults have a political cost and politicians

have an incentive to gamble for redemption

• Good politicians

Why delayed defaults?• Good politicians

• Strategic defaults have large reputational costs but unavoidable defaults are excused

– (Theory: Grossman & Van Huyck, 1988; Evidence on the costs of default: Borensztein and Panizza, 2009)

• Countries use self-flagellation to signal that the default is unavoidable

• This is inefficient• A structured mechanism could “certify”

unavoidable defaults, avoid unnecessary suffering and, by increasing recovery values, reduce borrowing costs

– A possible answer to Dooley’s dilemma

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References• U. Panizza, F. Sturzenegger, and J. Zettelmeyer (2009) "The

Economics and Law of Sovereign Debt and Sovereign Default" Journal of Economic Literature

• B. Eichengreen, R. Hausmann, and U. Panizza (2003) “The Pain of Original Sin” University of Chicago Press

• E. Borensztein, and U. Panizza (2009)"The Costs of Sovereign Default" IMF Staff Papers

• E. Levy Yeyati and U. Panizza (2010) "The Elusive Cost of Sovereign Default," Journal of Development Economics

• E. Borensztein, E. Levy Yeyati, and U. Panizza (2006) Living with Debt, Harvard University Press and IDB

• C. Campos, D. Jaimovich, and U. Panizza (2006) “The Unexplained Part of Public Debt,” Emerging Markets Review

• U. Panizza and A. Presbitero (2012) “Public Debt and Economic Growth: Is There A Causal Effect” MoFir Working paper

Debt, Debt Crises, Politics and Currency Unions

Ugo Panizza

UNCTAD & The Graduate Institute, Geneva

These are my own views

debt, debt crises, politics, and currency unions - unich.it · 04/07/2012 1 debt, debt crises,...

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