“Europe, You’re Down: Cyclicality and 

the Sovereign Debt Crisis”

REAI International Advisory BoardHarvard Faculty Club, Nov. 14, 2012

Jeffrey FrankelJeffrey FrankelHarpel ProfessorHarpel Professor

“You’re Up; You’re Down”

Cyclicality and Fiscal Policy:• The question “What is the right fiscal policy,

Austerity or Stimulus?” is as foolish as the question “Should a driver turn west or east?”

• It depends where he is in the road.– Sometimes west is the right answer, sometimes east.

• “The boom, not the slump, is the right time for austerity at the Treasury.”- John Maynard Keynes (1937) Collected Writings

Most experience with sovereign debt problems during our lifetimes arose in developing countries

• Recycling of petrodollars after 1974 -– ended in the international debt crisis of 1982

• and the Lost Decade of growth in Latin America,

• Emerging market inflows in 1990s– ended in the currency crashes of the late 1990s

• in Mexico, East Asia, Russia, Turkey, Argentina…

Most Emerging Market countries learned from the sovereign debt crises of the 1980s & 1990s.

But many leaders in advanced economies failed to do so.

• They thought it could never happen to them.

• Most notably, leaders of euroland,– even after the periphery countries

violated the deficit & debt ceilings of Maastricht and the SGP;

– And even after the Greek crisis hit in late 2009 !

But Reinhart & Rogoff remind us: sovereign default is an old story, including among advanced countries –This Time is Different, updated in “From Financial Crash to Debt Crisis,” 2010

Sovereign External Debt: 1800-2009. Percent of Countries in Default or

Restructuring50%-

Sources:Lindert & Morton (1989), Macdonald (2003), Purcell & Kaufman (1993), Reinhart, Rogoff & Savastano (2003), Suter (1992), and Standard & Poor’s (various years). Notes: Sample size includes all countries, out of a total of sixty six listed in Table 1, that were independent states in the given year

1980s1930s1870s

1830s

Some defaulters, since the Napoleonic Wars

Sources: S & P; Kenneth Rogoff & Carmen Reinhart; http://jongoodwin.com/2010/04/15/die-rechnung/

Which governments have defaulted?

Carmen Reinhart & Kenneth Rogoff found a growth threshold in Debt/GDP of 90%

MoneyHoney blog, Feb.20, 2010 ‘Growth in a Time of Debt’

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The historic role reversal• Debt levels among rich countries (debt/GDP ratios > 80%)

are now more than twice those of emerging markets– and rising rapidly.

• Some emerging markets have earned credit ratings higher than some so-called advanced countries.

• Over the last decade some emerging market countries finally developed countercyclical fiscal policies:

• They took advantage of the boom years 2003-2007 – to run primary budget surpluses and cumulate reserves.

• By 2007, Latin America had reduced its debt to 33% of GDP, – vs. 63 % in the US.

– And so were able to respond to global recession of 2008-09 .

But weaker in advanced economies.

World Economic Outlook, IMF, April 2012

Public finances since 2001have become much stronger in EMs

Public finances since 2001have become much stronger in EMs

Ratio of public debt to GDP among advanced countriesis the highest since the end of WW II

Source: Carlo Cotarelli “Making Goldilocks Happy,” IMF, Apr. 20, 2012

Country creditworthiness is now inter-shuffled“Advanced” countries (Formerly) “Developing” countriesAAA Germany, UK Singapore, Hong KongAA+ US, FranceAA Belgium ChileAA- Japan ChinaA+ KoreaA Malaysia, South AfricaA-Brazil, Thailand, BotswanaBBB+ Ireland, Italy, Spain BBB- Iceland Colombia, IndiaBB+ Indonesia, PhilippinesBB Portugal Costa Rica, JordanB Burkina FasoSD Greece

S&P ratings, Feb.2012 updated 8/2012

After failing to take advantage of the 2002-07 expansion to reduce debt/GDP ratios, Greece and

some other European countries are now on unsustainable debt paths

-- all the worse from applying austerity at the wrong time.

Spreads for Greece, etc., were near zero, 2001-07,but then shot up in 2008 and, esp., 2010-12.    

13Market Nighshift Nov. 16, 2011

Quality of fiscal policy-making

• Fundamentally: Quality of institutions.– This does not mean “tough” rules –

like SGP, debt ceiling or BBA – which lack enforceability.

– Better would be structural budget targets (Swiss) with forecasts from independent experts (Chile).

– One third of developing countries since 2000 have graduated from pro-cyclical spending to countercyclical,

– even while US, UK & euro countries have forgotten how to run countercyclical fiscal policy,

• and instead enact fiscal expansion in booms & contraction after recessions.

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Procyclical fiscal policy

• Definition: Governments raise spending or cut taxes in booms; and are then forced to retrench in downturns,thereby exacerbating economic upswings & downswings.

• E.g., the correlation between spending & GDP was positive.

• Historically, this has been true in developing countries.

Correlations between Govt. Spending & GDP1960-1999

procyclical

G always used to be pro-cyclical for most developing countries.

countercyclical

Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours”

Pro-cyclical spending

Counter-cyclical spending

}

In the last decade, about 1/3 developing countries

switched to countercyclical fiscal policy:Negative correlation of G & GDP.

Frankel, Vegh & Vuletin (2012)

procyclical

countercyclical

Correlations between Govt. Spending & GDP2000-2009

To summarize the fiscal role reversal,

• Many important emerging markets have, so far this century, achieved:– Lower debt levels than advanced economies;– improved credit ratings;– lower sovereign spreads; and– less procyclical fiscal policies.

Rules and optimism bias in official forecasts

• Fiscal rules are the current fashion. Do they help?

• The SGP has utterly failed– Angela Merkel’s fiscal compact may be no better.

• As such rules have failed in the US: – Gramm-Rudman-Hollings– Debt ceiling legislation– Balanced Budget Amendment, if we had one.

• Optimism bias in forecasts is worse among the € countries supposedly subject to the budget rules of the SGP,– presumably because official forecasters feel pressure to announce

they are on track to meet budget targets even if they are not.– When euro country deficits strayed above the 3% GDP limit,

governments would adjust their forecasts, but not their policies.

http://ksghome.harvard.edu/~jfrankel/ Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/

Writings by Jeffrey Frankel on fiscal policy: • “The Future of the Currency Union,” written Oct. 2012, for Academic Consultants Meeting, The Challenges of the Euro Crisis, Federal Reserve Board

•“On Graduation from Fiscal Procyclicality,” with C.Végh & G.Vuletin Journal of Development Economics, 2012. Summarized in "Fiscal Policy in Developing Countries: Escape from Procyclicality," Vox.eu, 2011. NBER WP 17619.

•"Over-optimism in Forecasts by Official Budget Agencies and Its Implications," Oxford Review of Economic Policy Vol.27, Issue 4, 2011, 536-562. NBER WP 17239; Summary in NBER Digest, Nov.2011.

•“A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” forthcoming, Fiscal Policy and Macroeconomic Performance, 2012. Central Bank of Chile WP 604, Jan.2011.

•“A Lesson From the South for Fiscal Policy in the US and Other Advanced Countries,” Comparative Economic Studies. 53, no.3, Sept.2011.

•“Snake-Oil Tax Cuts,” 2008, EPI, Briefing Paper 221. HKS RWP 08-056

•“The ECB’s Three Big Mistakes,” VoxEU, May 16, 2011.•"Let Greece Go to the IMF," Jeff Frankel’s blog, Feb.11, 2010.•“‘Excessive Deficits’: Sense and Nonsense in the Treaty of Maastricht; Comments on Buiter, Corsetti and Roubini,” Economic Policy, Vol.16,1993.

Appendices• 1) The example of Greek debt

– And the euro crisis

• 2) Sovereign spreads

• 3) Institutions for countercyclical fiscal policy

• 4) US debt woes

Appendix 1:The example of Greek debt

The Greek budget deficitnever got below the 3% of GDP limit,

nor did the debt ever decline toward the 60% limit

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Even Greece’s primary budget deficithas been far in excess of 3% since 2008

24

Source: IMF, 2011.I. Diwan, PED401, Oct. 2011

Optimism bias in official forecasts, continued

• Fiscal rules are the current fashion. Do they help?• Example of failure of fiscal rules

– in the presence of official forecast bias

• The Greek government projected in 2000 that its budget deficit would shrink– below 2% of GDP one year in the future and – below 1% of GDP two years into the future, and – that it would swing to surplus 3 years into the future.

• The actual deficit: 4-5% of GDP, well above the 3%-of-GDP ceiling.

Even though true Greek budget deficits in most years were far in excess of the supposed limit (3% of GDP),

26Source: Frankel & Schreger (2011)

the the official budget forecasts were always rosy.official budget forecasts were always rosy.

Until, in 2009, the bottom fell out of the budget.

Copyright 2007 Jeffrey Frankel, unless otherwise noted

WesternAsset.com

Bpblogspot.com

↑ Spreads shot up in 1990s crises,• and fell to low levels in next decade.↓

Spreads rose again in Sept.2008 ↑ , • esp. on $-denominated debt • & in E.Europe.

World Bank

Appendix 2: Sovereign spreads

Sovereign spreads depend on risk perceptions,as reflected in the VIX

(option-implied volatility of US stock market)

Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, 2011

Risk on

Riskon

Riskoff

World Economic Outlook, IMF, April 2012

One indication of improved EM creditworthiness:One indication of improved EM creditworthiness: EM sovereigns used to have to pay higher interest rates EM sovereigns used to have to pay higher interest rates

than many US corporates (BB), but now pay less.than many US corporates (BB), but now pay less.

Appendix 3: Countries with good institutional quality tend to be the ones that have attained countercyclical fiscal policy

Copyright 2007 Jeffrey Frankel, unless otherwise notedAPI-120 - Macroeconomic Policy Analysis I

Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Frankel, Vegh & Vuletin (2012)

proc

yclic

al

→

Building-in counter-cyclical fiscal policyBuilding-in counter-cyclical fiscal policyChile’s fiscal institutions Chile’s fiscal institutions sincesince  20002000

11st st rule – Governments must set a budget targetrule – Governments must set a budget target= 0 in 2008 under Pres. Bachelet.  = 0 in 2008 under Pres. Bachelet.     

22ndnd rule – The target is structural: rule – The target is structural: Deficits allowed only to the extent thatDeficits allowed only to the extent that

(1) output falls short of trend, in a recession, or(1) output falls short of trend, in a recession, or(2) the price of copper is below its trend.(2) the price of copper is below its trend.

33rdrd rule – The trends are projected by 2 panels rule – The trends are projected by 2 panels of independent experts, outside the political process.of independent experts, outside the political process.

Result: Chile avoided the pattern of 32 other governments, Result: Chile avoided the pattern of 32 other governments, where forecasts in booms are biased toward over-optimism,where forecasts in booms are biased toward over-optimism,

which is why Chile ran surpluses in the 2003-07 boomwhich is why Chile ran surpluses in the 2003-07 boomwhile the U.S. & Europe failed to do so.while the U.S. & Europe failed to do so.

Appendix 4: US deficit woes

• The US has mismanaged its finances as badly as Europe.– The US doesn’t have the excuse of 17 legislatures,– just two deadlocked political parties.

• It is a long-term problem:– i) Future deficits in “entitlement spending”

• social security & Medicare.

– ii) Current budget deficits since 1981• Steps in 1990s to restore surplus worked,• but were reversed in 2001.

The US national debt as a share of GDPSource: CBO, March 2012

Source: “The Procyclicalists: Fiscal Austerity vs. Stimulus ,” Jeff Frankel’s blog, July 25th, 2012

The Procyclicalists: Some US politicians dismiss the need for fiscal discipline during periods when growth is strong, thus adding to the upswing

-- only to decide the budget deficit is an urgent problem when growth is weak, thus working to exacerbate the downturn

One political obstacle, above all others

• One of the two political parties has been dominated by a minority who say fiscal balance is urgent, yet also say it can be done entirely by cutting domestic spending:– They want to cut taxes & raise military spending

at the same time as eliminating the deficit,– which is mathematically impossible.

• Prevents any sort of deal like 1990– which slowed spending growth

& raised taxes during the 1990s.

The game of “Chicken”

In the 1955 movie Rebel Without a Cause, whoever jumps out of his car first supposedly “loses” the game.

James Dean does; but the other guy miscalculates and goes over the cliff.

The debt-ceiling game of “chicken”

• In the summer of 2011, “fiscal conservatives” threatened government default if their demands were not met.– The resulting political dysfunction led S&P

to downgrade US bonds from AAA to AA.

• A last-minute solution postponed the deadline to the end of 2012:

• The Fiscal Cliff:– If no action is taken then, (i) all tax cuts expire,

(ii) all discretionary spending is cut drastically • ½ domestic, ½ military,

– (iii) => the most predictable and needless recession in US history– (iv) the debt ceiling law is violated anyway.