Transcript “Europe, You’re Down: Cyclicality and the Sovereign Debt Crisis” Jeffrey Frankel Harpel Professor REAI International Advisory Board Harvard Faculty Club, Nov.

“Europe, You’re Down:
Cyclicality and
the Sovereign Debt Crisis”
Jeffrey Frankel
Harpel Professor
REAI International Advisory Board
Harvard Faculty Club, Nov. 14, 2012
“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 Restructuring
50%-
1830s
1870s
1930s
1980s
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
Which governments have defaulted?
Some defaulters, since the Napoleonic Wars
Sources: S & P; Kenneth Rogoff & Carmen Reinhart;
http://jongoodwin.com/2010/04/15/die-rechnung/
Carmen Reinhart & Kenneth Rogoff
found a growth threshold in Debt/GDP of 90%
MoneyHoney blog, Feb.20, 2010
‘Growth in a Time of Debt’
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 .
8
Public finances since 2001
have become much stronger in EMs
But weaker in advanced economies.
World Economic Outlook, IMF, April 2012
Ratio of public debt to GDP among advanced countries
is 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
AAA Germany, UK
AA+ US, France
AA
Belgium
AA- Japan
A+
A
ABBB+ Ireland, Italy, Spain
BBB- Iceland
BB+
BB
Portugal
B
SD
Greece
(Formerly) “Developing” countries
Singapore, Hong Kong
Chile
China
Korea
Malaysia, South Africa
Brazil, Thailand, Botswana
Colombia, India
Indonesia, Philippines
Costa Rica, Jordan
Burkina Faso
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.
Market Nighshift Nov. 16, 2011
13
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.
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.
15
Correlations between Govt. Spending & GDP
1960-1999
Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours”
procyclical
Pro-cyclical spending
countercyclical
Countercyclical
spending
G always used to be pro-cyclical
for most developing countries.
Correlations between Govt. Spending & GDP
2000-2009
procyclical
Frankel, Vegh & Vuletin (2012)
countercyclical
In the last decade,
about 1/3 developing countries
switched to countercyclical fiscal policy:
Negative correlation of G & GDP.
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.
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.
http://ksghome.harvard.edu/~jfrankel/ Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/
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 deficit
never got below the 3% of GDP limit,
nor did the debt ever decline toward the 60% limit
23
Even Greece’s primary budget deficit
has been far in excess of 3% since 2008
Source:
IMF, 2011.
I. Diwan,
PED401,
Oct. 2011
24
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),
the official budget forecasts were always rosy.
Until, in 2009, the bottom fell out of the budget.
Source: Frankel & Schreger (2011)
26
Appendix 2: Sovereign spreads
↑ 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.
WesternAsset.com
World Bank
Copyright 2007 Jeffrey Frankel, unless
otherwise noted
Bpblogspot.com
Sovereign spreads depend on risk perceptions,
as reflected in the VIX
(option-implied volatility of US stock market)
Risk
off
Risk on
Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, 2011
Risk
on
One indication of improved EM creditworthiness:
EM sovereigns used to have to pay higher interest rates
than many US corporates (BB), but now pay less.
World Economic Outlook, IMF, April 2012
procyclical →
Appendix 3: Countries with good institutional quality tend
to be the ones that have attained countercyclical fiscal policy
Frankel, Vegh & Vuletin (2012)
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Building-in counter-cyclical fiscal policy
Chile’s fiscal institutions since 2000
1st rule – Governments must set a budget target
= 0 in 2008 under Pres. Bachelet.
2nd rule – The target is structural:
Deficits allowed only to the extent that
(1) output falls short of trend, in a recession, or
(2) the price of copper is below its trend.
3rd rule – The trends are projected by 2 panels
of independent experts, outside the political process.
Result: Chile avoided the pattern of 32 other governments,
where forecasts in booms are biased toward over-optimism,
which is why Chile ran surpluses in the 2003-07 boom
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 GDP
Source: CBO, March 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
Source: “The Procyclicalists: Fiscal Austerity vs. Stimulus ,” Jeff Frankel’s blog, July 25th, 2012
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.