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.

Saturday, October 26, 2013

Policy responses to debt overhang: Asset price support

The role of sectoral balance sheets, and their linkages, is used oftentimes to explain the euro area crisis and the sluggish recovery. Richard Koo's holy grail narrative of balance sheet recessions experiences a post-academic renaissance. A recent Vox piece by Jorda, Schularick, and Taylor adds to the empirical analysis in this field. (Let me forgive them to cite the infamous 90 percent public debt-to-GDP threshold.)

Their research shows that in advanced economies, balance sheets of the household and financial sectors empirically play a pivotal role in explaining the outbreak of crises and the speed of recovery. Strong government balance sheets, i.e. low public debt and a healthy structural balance (also coined "fiscal space"), help to mitigate a shock.

These are all useful empirical insights, but what are the mechanics which need to be understood to develolp effective policy responses? This is yet less clear. This blog argues for the importance to prevent asset price undershooting, using the example of the recent household debt crises in Ireland, Spain, and--to a lesser degree--the UK and US.

In these countries, households thrive to deleverage, i.e., shrink and repair their balance sheets from a debt load which exceeded 100 percent of GDP. Agents save instead of spend, in turn depressing incomes and output. For instance, household savings rates since 2007 jumped by 4-5 percentage points in Ireland and the UK. House price declines of 50 percent in Ireland, 30 percent in Spain, and 20 percent in the US have spread negative equity which in turn induced mortgage default, crippling the banking system.

The usual policy response of bank stress tests, bank recapitalization and the like has ensured banks are mostly sound and well capitalized. Also, interest rates, the core monetary policy tool, has in part helped households' debt burden to become more affordable and reduce defaults. But many banks couldn't benefit from lower rates, owing to impaired monetary transmission channels.

So... what other policies are needed?

Direct debt relief would help but in many cases is unaffordable. While household debt relief following the Great Depression or in the fairly small mortgage sector in Iceland worked, the public purse is too small for such a policy response in places like Spain, Ireland, and the Netherlands where household debt is higher and public debt not low. If markets see such a policy as undermining public debt sustainability and demand higher risk premia, banks' funding conditions usually worsen as well, offsetting the benefit of such policy.

What looks more promising is a financial policy that buffers asset prices which, given the size of balance sheets, could have a very wideranging effect. Generally, market prices often get depressed amid thin trading in the aftermath of popped price bubbles, and it takes little to avoid asset prices to undershoot their fundamental levels. This will prevent damage from balance sheets of all agents holding that asset. Thus, in countries with a high degree of home ownership, a policy that carefully avoids excessive house price slumps can bring broad benefits to households' balance sheets.

In general, this line of argument supports asset purchases. Yet, not all assets can in any practical way be purchased by central banks (think houses). Thus, there is also a role for regulatory policy to be used to support asset prices. Procyclical tightening of prudential and tax rules, such as in the Netherlands, is not what I mean. 

Tuesday, October 22, 2013

A second Greek debt restructuring (2): A repeat?

Public debt is very high, public and private investment has collapsed, and the economy shrinks. Official lenders provide the financing needed to service debt. This situation describes not only Greece today, but also the many developing countries in the 1980s debt crises.

This blog post applies the insights of that time provided by Krugman (1988, 1989) and Froot (1989) to the current situation in Greece.

In a situation where the future repayment capacity is exogenous yet uncertain, creditors are better off never to grant debt relief. While the expected value of the repayment may be below the nominal value of debt owed--as is surely the case for Greece--the creditors' claim has some option value. As Krugman (1988) writes, creditors would be "foreclosing the possibility of benefitting from any later good fortune on part of the country."

Creditors have thus the collective interest in postponing the day of reckoning: they keep Greece afloat to avoid an immediate default. The collective action problem arising in cases with multiple debtors is not grave: most of Greece's debt is owed to its European partners and the IMF, containing the gains from free riding that is reaped by the few private bondholders. And given Greece reaches a primary surplus next year, most of new financing needed is actually to spent to service debt! Ergo, Greece is not on the falling branch of a debt Laffer curve, unless...

...the repayment capacity is not exogenous. If the debt overhang leads to underinvestment, reducing Greece's potential output in the future, then a case could be made for forgiving debt today. In the 1980s debt crises, the debt relief in the form of debt rescheduling was found to depress future repayment capacity where there is no new, additional lending supplied. (Froot writes "if investment incentives are present… the optimal debt-relief package will include an infusion of new lending.") However, the Troika programs for Greece have determined the amounts of public investment and provide for their financing. This leaves the question whether private investment is affected by the debt overhang: Greece's low sovereign rating (a C by Moody's) may deter foreign investors, and uncertainty about a future debt restructuring may incentivize domestic savers to invest abroad. Evidence for such debt overhang effect is hard to pin down. 

How to solve this trade-off between the keeping the option of full repayment while limiting the adverse consequences of debt overhang? By committing to reduce debt to 124 percent by 2020 and substantially below 110 percent in 2022, the European partners cut this Gordian knot: They keep the option to reap any upside if Greece rebounds while trying to remove uncertainty about Greece's debt stock at the end of this decade.

Will it work? There is a sad tradition among European politicians to duck their previous  commitments. Conversely, the commitment could lead to moral hazard on Greece's behalf, which could slow the necessary adjustment or even bring forward debt creating outlays right before the 2020 cutoff.

As usual, nothing is panacea