Cliff # 1

About cliffeconomics

This blog offers original economic thought and policy recommendations on Germany, the euro area, and whatever cliff has on his mind.

Cliff # 3

About cliff

The author is an economist specialized in financial and macroeconomic policy analysis. All posts present a personal opinion, and all analysis is based on publicly available information.

Cliff # 1

About cliff

The author is an economist specialized in financial and macroeconomic policy analysis. All posts present a personal opinion, and all analysis is based on publicly available information.

Tuesday, September 20, 2011

Economics 1-ohhh-1: Ways to resolve a debt overhang

Without implication, imagine there is a small country within a currency union. This country, let's call it Olive, suffers from too high debt and a liquidity crisis. Imagine there is another, large and solvent country that is called Oak. And on top of that, assume politicians really want to end the crisis. This sounds like a distant imagination, doesn't it?

What can be done? Debt crises can be overcome in two ways: (i) growth and (ii) transfers, whereby transfers can take a zillion different shapes with different distributional effects, in particular: (a) inflation, (b) grants by Oak to Olive, (c) default by Olive.

Growth is a first-best solution. Instead of producing traditional olives, a coincidental invention allows olive trees to grow gourmet olives with incredibly better taste. The resulting jump in value creation allows Olive to raise more taxes and pay off its debts. Everybody would be better off and there are no obvious distributional consequences. (Although those with savings for their retirement would also prefer to buy gourmet olives from their savings, but have only saved enough to afford traditional olives. In terms of the economics of happiness, tough luck!)

This is where we run out of Wunderland solutions. Gourmet olives remain a dream. Realizing this, politicians go on to examine transfers. Transfers can be seen as tax collected from some and handed out to others.

First, there is the inflation tax. Assume that the central bank has successfully been captured by politicians (another tough fact of life) and helps out by getting inflation going. (Of course, this is not as easy as it sounds.) Prices rise, and so does the current value of (olive) output, while the current value of promised future payments declines. This is nothing else than a tax on future payments, whereby the tax is higher the further the payment lies in the future. Creditors with long-term (fixed rate) savings lose most, while debtors with long-term (fixed rate) debts gain most. Usually, government debt and pension savings have the longest duration. Hence, inflation redistributes wealth from creditors to debtors, and mostly so from pension funds (owned by the working population) to governments. This subtle way of wealth distribution takes place across the entire currency union, not only in Olive! Besides the question of stocks (of savings and debt), there is also a question of flows (of income and consumption): prices rise before incomes do, hitting in particular low wage earners. Finally, as is the case for all taxes, inflation has distortionary effects. In particular, inflation leads to higher interest rates, elevating the cost of investments, and thus lowering productivity growth across the monetary union. But politicians still love inflation: it is a very subtle tax, and the electorate may fail to see the true cost of it--unless the central bank completely loses its credibility and an inflation spiral gets out of control. So, political cost for politicians may be low. But costs from economic distortion in saving and investment as well as credibility costs of the central bank are substantial! Hm, doesn't sound too good, does it?

Second, there are unconditional transfers, or grants. The distributional effects are explicit: taxpayers in Olive win, taxpayers in Oak lose. Full stop. The crisis should be over, and Oak may actually suffer less than thought: To the degree that Olive's creditors are actually residents of Oak, the inter-country transfer turns out to be an intra-Oak-transfer. In other words, Oak redistributes wealth from all taxpayers to some creditors. Thus, to some degree the transfer is self-serving and may be cheaper to Oak than the distortionary inflation tax or the mess that may come out of a default (see below). The problem is not the feared reach into poor-Oak-taxpayers' pockets (figurated in large letters all over tabloid newspapers), but a conceptual one: critics claim that transfers induce "moral hazard": A transfer saves Olive's politicians from the pain of cleaning out their olive orchard, and the problem is more likely to repeat itself. This critique is not entirely true. Any crisis hurts Olive's government no matter what. Therefore, they have the incentive to bring their orchard in order. But they probably won't turn it into an Oak grove. Depending how well the ex-ante disciplining mechanisms are that force each member of the currency union to keep its orchards, groves, or whatever in best order, transfers are the least disruptive solution. This is the idea behind the fiscal union.

Third, there is default. Olive would just walk away from its debts, keeping all olives for herself, in fact imposing a tax on all creditors. If it is known who the creditors are, it is easy to identify the direct distributional effect of this wealth transfer: the creditors are often banks and pension funds. Ergo, wealth is being transfered from depositors and pension savers (who partly may not be residents of Olive, but rather Oak) to the government. The solution does not sound so different from transfer by inflation except that the transfer is much more direct and has less repercussions across the entire monetary union... hang on! Really? Conventional wisdom is that default is extremely costly because it sends a shock wave through the entire domestic economy. Contagion occurs because the government defaults on banks and pension funds, these default on depositors and pension claimholders, these in turn default on their mortgages, and so on. Why does the same not happen with the inflation tax? Because inflation shrinks everybody's assets and liabilities, distributing the burden very evenly. With default, eventually the burden will also be distributed through the system, but by means of small explosions that go off here and there. Key for avoiding this chain reaction is to identify the first line of vulnerable entities and protect them. For instance, Oak gives Olive a bridge loan to "buy time" and allow the banks to build warchests (e.g., capital buffers for banks). Or, Olive builds a central reserve to help the victims (e.g., a bank recapitalization fund financed by, er, well, probably Oak). This sounds difficult, and it surely is. The politics of it are messy, and this is about where we are right now. Ex ante it is not clear what the distributional consequences and deadweight losses are. Default taxes tend to shake up the political elite, and this may actually be the nasty truth of the political economy because backbench politicians often gain from shake-ups. (Just read "Freakonomics" to learn why small drug dealers love to kick off gang wars.) Unless well planned, the ultimate distortionary effect of a default can be substantial: incomplete information about the contagion channels ("who is an emperor without clothes?") can lead to a general loss in confidence (not only in Olive, but across the entire currency union). This will disrupt financial intermediation or, in other words, discourage saving and investment, and lower productivity growth. Avoiding this requires strong political will and as much excellent technical planning as execution. In an idealized world, the distributional consequences could be very limited and direct. The inconvenient truth is that in most cases it turns messy at some point.

Assuming that there are no gourmet olives, there will be a tax on Oak: Grants like default like inflation are all taxes. Whatever the tabloids try to convey to Oak's taxpayers, there will be some costs to preserve the currency union. And just because the costs of a grant from Oak to Olive is so obvious, there is no good reason to believe that the hidden costs from default or inflation are any lower. Grants are not a bad choice if the disciplining devices avoid moral hazard. Default is not a bad choice if the defense shield against contagion works. And inflation... well, unlikely to solve the problem anytime soon.


  1. Interesting topic. However if your choice is inflation there many many negative effects. BUT Greece for example can not chose inflation because he is in European monetary union and they have Euro. If yo ask me default is maybe best chose... it will produce short run economic contraction but in the long run you can solve your debt problem. Situation in world is that most of countries (Greece, USA, italy, spain) will not be able to pay their debts. This will probably trigger large world recession.