CEPR-RIETI Workshop Presenter: Prof. Wouter DEN HAAN London School of Economics / CEPR December 10, 2015 Handout http://www.rieti.go.jp/en/index.html Research Institute of Economy, Trade and Industry (RIETI) “Fiscal Sustainability”
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CEPR-RIETI Workshop
Presenter: Prof. Wouter DEN HAAN London School of Economics / CEPR
December 10, 2015
Handout
http://www.rieti.go.jp/en/index.html Research Institute of Economy, Trade and Industry (RIETI)
“Fiscal Sustainability”
1
Fiscal Sustainability and
Self-Fulfilling beliefs
2
Overview
• The basics• Sustainability of sovereign debt is something you can loose quickly
• Fundamental versus self-fulling problems• They are related
• The role of monetary policy• Solution or part of the problem
• Conventional monetary policy
• Unconventional monetary policy
3
The Basics
Dt+1 = (1+r) Dt - St+1
• D: nominal government debt
• S: the nominal primary surplus (revenues minus expenses before interest payments)
• r: nominal interest rate
4
The Basics
Dt+1 = (1+r) Dt - St+1
Divide through by GDP (Yt+1)
Dt+1 / Yt+1 = (1+r) Dt/ Yt+1 - St+1 / Yt+1
= (1+r)[Dt/ Yt][Yt / Yt+1] - St+1 / Yt+1
= [(1+r)/(1+g)] Dt/ Yt - St+1 / Yt+1
5
The Basics
dt+1 (1+r-g) dt - st+1With:
dt = Dt / Yt
st = St / Yt
Everything is in real terms now
6
The Basics
dt+1 (1+r-g) dt - st+1
• This formula is based on many simplifications, but
• There is an important lesson:
If g is low relative to r then debt is unsustainable
unless primary surplus is high enough
7
Debt Limits
Source: OECD (2015) & Fournier and Fall (2015)
8
Fundamental
versus
Self-fulfilling Problems
9
When Becomes Debt Unsustainable?
I: Fundamental problems
• Structural problems low g
• Low commitment to debt repayment high r
• Cyclical problems low s
• High initial debt high r
10
When Becomes Debt Unsustainable?
II: Self-fulfilling problems
• Market looses confidence high r
• Debt increases higher r
• Market looses confidence etc
Are these empirically relevant?
11
0
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l-201
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10 yr gov't bond yields (%)
Greece
Ireland
Italy
Spain
Portugal
Germany
Fundamental or Sustainable Problem?
12
Mario Draghi (2012)
“The assessment of the Governing Council is that we are in … a ‘bad equilibrium’, namely
an equilibrium where you may have self-fulfilling expectations that feed upon themselves and generate very adverse
scenarios. So, there is a case for intervening, in a sense, to ‘break’ these expectations …”
Do Self-fulfilling Equilibria exist?
ECB Press conference, transcript from the Q&A, September 6 2012
13
Self-Fulfilling Debt Crisis
Source: De Grauwe and Ji (2013)
14
Monetary Policy
15
De Grauwe (2011)
… the UK government is ensured that the liquidity is around to fund its debt. This means
that investors cannot precipitate a liquidity crisis in the UK that could force the UK
government into default. There is a superior force of last resort, the Bank of England”
Role of Monetary Policy & Unsustainable Debt
16
Gross Government Debt (%GDP)
17
10-year sovereign debt yield
18
Krugman (2011)
“Many people now accept the point … that … countries that have given up the ability to
print money become vulnerable to self-fulfilling panics in a way that countries with
their own currencies aren’t …”
Role of Monetary Policy & Unsustainable Debt
19
Role of Monetary Policy & Unsustainable Debt
• Traditionally Monetary Policy was thought to be the problem!
• Conventional Monetary Policy
• Unconventional Monetary Policy
20
Role of Monetary Policy & Unsustainable Debt
Key papers in the literature:
• Calvo (1988)
• Corsetti and Dedola (2014)
• Hall and Reis (2015)
21
Monetary PolicySolution or Source of Problem
Calvo (1988)
“… The possible empirical relevance of the non-uniqueness issue becomes apparent when
examining the role of interest-bearing government debt. … Will … debt be paid off in
full, will the government find it optimal to resort to higher inflation or currency
devaluation to diminish the burden of the debt, etc.?”
22
Monetary PolicySolution or Source of Problem
• Unpredictable monetary policy was believed to be important for risk premia and high interest rate
•
• Independent monetary policy can be source of unsustainable debt
23
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10 yr gov't bond yields (%)
Greece
Ireland
Italy
Spain
Portugal
Germany
Monetary Policy: Problem or Solution?
24
Calvo (1988)Easy to Get Self-fulling Crises
Setup:
• Simple two-period model
• No commitment: Government reoptimizes in period 2
• Rational investors
• Financing need government = B
• Interest Rate = R
25
Calvo (1988)No Default Equilibrium
26
Calvo (1988)No Default Equilibrium
27
Conventional
Monetary Policy
28
Calvo (1988)No Default because of Mon. Policy
29
Inflating Debt & Eliminating Self-fulfilling Panics
• Inflation must be unexpected• More likely if debt is long-term and issued during tranquil times
• The probability of government doing this (ever) must be low. If not, then investors would demand risk premium
30
Inflating Debt versus Regular (Partial) Default
• Even small partial default may have large fixed cost
• Small partial default through inflation probably not very costly
• Inflation means default on all debt, that is sovereign and private Inflation risk will increase yields on all debt
31
Monetary Policy & Eliminating Self-fulfilling Panics
Corsetti & Dedola (2014)
• Default because of self-fulfilling and fundamental reasons• 3 aggregate states:
• Expansion
• Recession
• Severe recession
• In period 2, government only reoptimizes with probability only self-fulfilling panic when fundamentals bad and/or government debt high
32
Corsetti and Dedola (2014)No Monetary Policy
33
Corsetti and Dedola (2014)Optimal Discretionary Monetary Policy
34
Monetary Policy & Eliminating Self-fulfilling Panics
Conclusion: Inflation possibility does not eliminate multiplicity
Why so little change?
• Agents are rational & inflation is costly
Why any change?
• Default and inflation are both distortionary, but there are advantages of smoothing these distortions
35
Unconventional
Monetary Policy
36
Unconventional Mon. Pol. Defined
Unconventional Monetary Policy Gov. Bond purchases
• Total liabilities of government (i.e. bonds + reserves) unchanged
• So why would this make any difference?
• Bonds ≠ reserves. Why?• Default risk different for bonds and reserves
• Interest rate could be different
37
Unconventional Mon. Pol. at Zero-Lower Bound
• Suppose i. Reserves are risk free and
ii. Economy is at zero-lower bond (ZLB)
• interest rate on gov. bonds interest rate on reserves
• unconventional monetary policy replaces risky government debt by risk-free asset with similar rate of return
• default equilibrium can disappear for sufficiently large bond purchases
38
Unconventional Mon. Pol. outside Zero-Lower Bound
• Suppose i. Reserves are risk free and
ii. Central bank pays interest on reserves
• interest rate on gov. Bonds (without default premium) interest rate on reserves
• unconventional monetary policy replaces risky government debt by risk-free asset with similar rate of return
• default equilibrium can disappear for sufficiently large bond purchases
39
Too Good to be True?
• If multiplicity can be broken by unconventional monetary policy
•
• Central banks should always engage in unconventional monetary policy
40
What is the Tricky Bit?
• Key in previous discussion is that central banks do not default
• Is that true?
• What happens if cental banks have negative equity?
41
Central Banks & Negative Equity
Two views
1. Central banks cannot have negative equity central bank may default or government recapitalizes central bank
2. Negative equity not a problem
Implied consequences
1. Default is not different unless this introduces a commitment mechanism for the government not to default
2. No default if central banks can have negative equity?
42
Central Banks & Negative Equity
Central bank balance sheet after default:
Assets Liabilities
Government Bonds 0 Reserves 1000Equity -1000
Is there a problem?
• Central banks can no longer reduce reserves in the usual way, that is by selling government bonds
•
• there could be default by inflation
• required reserves , which is similar to default
43
Central Banks & Negative Equity
Should we worry about central banks getting negative equity?
Hall and Reis (2015):
• FED (no default risk): There is risk for the FED losing the ability to stabilize prices given the historical volatility of interest rates and bond prices.
• ECB (with default risk): Little risk as long as default risk is priced into the bonds (that is, bonds can be bought cheaply).
• CBs with exchange risk: Here the situation is more problematic and it is important for such central banks to retain earnings during good times
44
References
Corsetti, G. And L. Dedola, 2014, The “Mystery of the Printing Press” Monetary Policy and Self-fulfilling Debt Crises, available at http://www.centreformacroeconomics.ac.uk/Discussion-Papers/2014/CFMDP2014-24-Paper.pdf.
De Grauwe, Paul, 2011, The Governance of a Fragile Eurozone, CEPS Working Document, No. 346, May 2011.
Fournier, Jean-Marc and Falilou Fall, 2015, Limits to Government Debt Sustainability, OECD Economics Department Working Paper No. 1229.
Hall, Robert E. And R. Reis, 2015, Maintaining Central-Bank Financial Stability under New-Style Central Banking, available at http://www.columbia.edu/~rr2572/papers/15-HallReis.pdf.
Krugman, P., 2011, Wonking Out About the Euro Crisis (Very Wonkish), available at http://krugman.blogs.nytimes.com/2011/08/08/wonking-out-about-the-euro-crisis-very-wonkish/
OECD, 2015, Achieving Prudent Debt Targets Using Fiscal Rules, OECD Economics Department Policy Notes, No. 28, July 2015.
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