Ken, what did you smoke?

It is rare for Cliff to comment on a policy proposal so absurd that no comment is needed. But Ken Rogoff, a highly respected professor at Harvard, tends to surprise.

In his article in the German Frankfurter Allgemeine Zeitung, reproduced in English here and base for his talk at INSM, a Berlin based think tank, Rogoff argues that the most efficient way to boost the euro area periphery is to forgive their debt.

Interestingly, the article does not explain why Rogoff believes this is most efficient, other than his belief that sovereign debt holders will be happy to chip in a maturity extension, as discussed recently at the IMF. But with the cost of EFSF/ESM loans minimal and market funding buoyant, the timing of Rogoff's argument is just too bizarre. Financial intermediation is just picking up again, and flush liquidity allowed Portugal to forego bailout funds and Ireland to think about their early repayment.

Why debt forgiveness now?

Read More

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. 

Read More

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. 

Read More

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.

Read More