Rethinking Public Debt and Fiscal Policy Guillermo Calvo Columbia University

2 Credit Market Rupture

3 Normal Times Private Sector DISSAVERS SAVERS

4 Credit Sudden Stop Private Sector DISSAVERS SAVERS The central problem is financial, and policy should focus on financial issues !!

Credit market Sudden Stop brings about excess supply of goods and services. “Lack of demand” is not a consequence of Sudden Anorexia or Sudden Loss of Self- Esteem! –However, these symptoms could develop afterwards as a result of drastic change in demand structure.

Global Issues First priority is to normalize financial system. If the government can borrow at low interest rates, it makes sense to stabilize aggregate demand to prevent –Irving Fisher Debt Deflation –Excess relative price volatility. In addition, social programs to protect unemployed and the poor.

However, high government expenditure crowds out private sector and may slowdown discovery of new equilibrium output pattern. This shows relevance of exit strategies. Fiscal deficit and large public debt are important issues but less critical than the previous ones in the short run.

The Current Situation in the US It is much more serious than Sudden Stops in Emerging Market economies (EMs). Sudden Stops were followed by a sharp increase in exports, while in the US exports have declined. 8

Exports (Goods and Services, quarterly data, seasonally adjusted) Source: Calvo and Loo-Kung (2010). AEM - GDP AEM - Exports US - GDP US - Exports

Moreover, EM recovery was accompanied by a sharp fall in real wages and real currency devaluation. In contrast, US real wages are flat or increased, and the dollar has appreciated in real terms. 10

Real Exchange Rate (Bilateral RER vis-a-vis the US for AEM, Multilateral Effective RER for US, quarterly data, seasonally adjusted) Source: Calvo and Loo-Kung (2010). AEM - GDP AEM - RER US - GDP US - RER

Real Wages (Wages deflated by CPI) Source: Calvo and Loo-Kung (2010). Average EMUS GDP Real Wages (right axis) quarters

As in EMs, bank credit in the US has dried up. Especially to small enterprises and households.

Real Credit (Claims on Private Sector over CPI, quarterly data) Source: Calvo and Loo-Kung (2010). AEM - GDP AEM - Credit US - GDP US - Credit

15 However, US Output is Recovering at a Rate Similar to EMs’ !! However, US Output is Recovering at a Rate Similar to EMs’ !!

Real GDP: AEM collapse vs. US subprime Crisis (quarterly data, seasonally adjusted) Source: Calvo and Loo-Kung (2010), Peak Trough

The US aggregate-demand drivers of output recovery are: Government Consumption Investment

Government Consumption (Gov. Final Consumption, quarterly data, seasonally adjusted) Source: Calvo and Loo-Kung (2010). AEM - GDP AEM – Gov. Cons. US - GDP US - Gov. Cons.

US Economic Predicaments Recovery is based on domestic aggregate demand, which does not help to resolve Global Imbalances. Fiscal stimulus is about to be phased out, and exports are weak, slowing growth. Domestic investment is likely to involve less labor-intensive activities, making employment-less recovery likely –which complicates politics and increases the probability of protectionism.

US Macro Policy Dilemmas Doing nothing risks triggering price deflation. This is dangerous because it is a self- reinforcing mechanism. I would favor relaxing financial constraints for small firms (the Fed reports that banks are voluntarily starting to do that). Government expenditure exacerbates Global Imbalance and slows down discovery. –But it could be the solution of last resort if monetary/credit policy fails.

Emerging Market economies Fiscal policy is less feasible because Flight to Quality is less likely to include EM public bonds. However, EM public bonds could be enhanced by World Bank programs. Infrastructure projects are attractive in many instances, and could be financed through PPP (Public-Private Partnership). EM government expenditure helps to resolve Global Imbalance.

Inflation, not deflation, is a possible problem. Therefore, Inflation Targeting is still a valid objective. However, credit policy should not be ignored, especially during Sudden Stop. International Reserves could be used to extend foreign exchange credit to critical sectors, like the export sector (as in Brazil 2002 and 2008/9).

Rethinking Public Debt and Fiscal Policy Guillermo Calvo Columbia University