Debts, Panics, and Depressions

Debts and Deficits Last time: -Conceptual issues of debts and deficits -Deficits and slower growth of potential Y in the closed economy -Deficits and foreign borrowing and lower national income (Y+net foreign earnings) in the open economy -Fiscal cliff Today: -The death spiral of debt and default -Keynes and the classical economist on deficit financing 2

Debt and financial crises “Political incentives for additional borrowing could change quickly if financial markets began to penalize the United States for failing to put its fiscal house in order. If investors become less certain of full repayment or believe that the country is pursuing an inflationary course that would allow it to repay the debt with devalued dollars, they could begin to charge a “risk premium” on U.S. Treasury securities. That could happen suddenly in a confidence crisis and ensuing financial shock. There is precedent for a financial disruption first contributing to large, chronic deficits and then in some cases contributing to the loss of investor confidence and even to a default on a nation’s debt. [However,] the unique position of the United States—because of its economic dominance and the dominant role of the dollar internationally—make it difficult to extrapolate from the experience of other nations in estimating the risk or timing of a financial crisis arising from failure to address the projected U.S. fiscal imbalance. [National Academy of Sciences panel, Choosing the Nation’s Fiscal Future, 2009] 3

American Econ Review, August 2011.

Misinterpretation by Deficit Commissioner “When the markets lose confidence in a country, they act swiftly and they act decisively. Look at Greece, look at Portugal, look at Ireland, look at Spain.* If they markets lose confidence in this country and we continue to build up these enormous deficits and debt, they will act swiftly and decisively.” [Erskine Bowles, Chair, President’s Commission] * BTW: This is completely wrong analytically. 5

Defaults and restructuring are endemic Default: A sovereign default is defined as the failure to meet a principal or interest payment on the due date (or within the specified grace period). These are often called “restructuring” or “repudiation” but have the same effect. 6

Reinhard and Rogoff, From Financial Crash to Debt Crisis, AER, 2011

Country crises as bank runs Problem arises because have an unstable equilibrium where country’s liquid liabilities >> its liquid assets. A higher debt → higher probability of default ( σ) → higher r risky → requires more budget cuts and less likely to pay → higher σ → eventually the country decides to default or restructure. Examples: Greece β=1.4. If markets put σ =5%, primary surplus ratio must be 7% of GDP. If Greeks start revolting, σ =10%, then required surplus goes to 14% of GDP. So have a good and bad equilibrium like bank runs. 8

Fiscal deficits plus loss of confidence pushes over the tipping point to where cannot refinance debts Country fiscal position Rising risk premium and interest burden

Unstable equilibrium 10

Unstable equilibrium 11 a Unstable equilibrium, tipping point Debt-GDP ratio (β)

EZ interest rates

Examples of unstable equilibria

The unfortunate weak currencies in the EZ Spain and UK had virtually same deficit and fiscal position in 2010.

Does this apply to the US? Question: What is the historical frequency of debt crises for countries with either fixed exchange rates or debts denominated in external currencies a la Greece, Italy, Spain, Argentina, etc.? Answer: average of 14 every year for last two centuries. Question: How many countries with flexible exchange rates and debts denominated in their own currency have had a foreign exchange crisis? Answer: I could not find one. 15

Two Views of the Great Unraveling (I): Soft Landing The final issue of Keynesian debt dynamics The two faces of saving and the deficit dilemma

17 What is the effect of deficit reduction on the economy? 1. In short run: Higher savings is contractionary Mechanism: higher S, lower AD, lower Y (straight Keynesian effect) 2. In long-run: Higher savings leads to higher potential output Mechanism: higher I, K, Y, w, etc. (through neoclassical growth model) Dilemma of the deficit: Should we raise G today or lower G?

Real output (Y) Inflation AD AS’ Impact of fiscal stimulus AS AD’ ?

The dilemma of the deficit To illustrate, I use a little simulation model built from our five equation IS-MP model plus a Solow growth model. Then compare (1) a large stimulus program to reach full employment (2) a balanced budget program Use historical data, calibrated model, and “plausible” projections of variables. 19

Stimulus v. balanced budget -Balance FE budget in 4 years -Stimulate enough to get to FE in 3 years 20

Actual deficits -Actual deficit is still large because of recession. 21

The long-term debt Have higher debt-GDP ratio for long time 22

But the economy pays the price -With fiscal austerity, have long period of stagnation. 23

The dilemma of the deficit Slower growth in potential with stimulus, but it doesn’t make up the difference. 24

25 Conclusions on Debt and Deficits Central long-run impact of fiscal policy is on POTENTIAL output through impact on national savings rate. But in deep recessions, particularly in liquidity trap, need larger deficits to stimulate ACTUAL output reach full employment. So policy needs differ in recession and full employment.

Final word on macroeconomics You have heard of the “hard sciences.” But macro is a “very hard science.” Why is it so challenging? Listen to the conversation between Keynes and the revolutionary physicist, Max Planck, that took place at high table in King’s College, Cambridge: “Professor Planck, of Berlin, the famous originator of the Quantum Theory, once remarked to me that in early life he had thought of studying economics, but had found it too difficult! Professor Planck could easily master the whole corpus of mathematical economics in a few days. But the amalgam of logic and intuition and the wide knowledge of facts which is required for economic interpretation in its highest form is overwhelmingly difficult.” So now it is in your hands!.