1. The Debt Challenge in Europe Alan Ahearne and Guntram Wolff October 2011

2. Outline The challenge: debt overhang and price adjustment. Large increase in private debt prior to the crisis. Balance-sheet adjustments underway. Examine previous experiences with corporate and household deleveraging. Options for policymakers.

3. Adjustment mechanisms in EMU Membership of euro imposes constraints on macroeconomic policy. Smooth economic adjustment depends crucially on the adjustment of intra-area real exchange rates and factor mobility (European Commission, 2006 and 2008). Competitiveness channel (EC, 2008; Honohan and Lane, 2003). Real interest rate channel (Walters critique). Factor mobility and Optimum Currency Areas (Mundell, 1961; McKinnon, 1963; and Kenen, 1969).

4. Competitiveness channel versus real interest rate channel The competitiveness channel is expected to outweigh the real interest rate channel over the longer haul. (European Commission, 2006). “What is lost when inflation is above the average is much greater than what you could theoretically gain with a lower level of real rates. This is very important” (Jean-Claude Trichet, 2006).

5. But what about debt? Interaction between public debt and private debt. –Large-scale fiscal consolidation → reduce income → financial distress and banking problems → further depress economic growth (Eggertsson and Krugman, 2010). Interaction between needed improvements in competitiveness and high levels of private indebtedness. –Depreciation of the real exchange rate through cuts in nominal wage rates and prices eventually boosts incomes. But there’s a timing issue. (Fisher, 1933). Labour mobility and mortgage debt.

6. High debt levels in crisis countries Figure 1: Net external financial assets as % of GDP (2009) Figure 2: Net assets in the different domestic sectors as % of GDP (2009) Source: EUROSTAT

7. Significant competitiveness adjustments required

8. Fiscal deficits have offset increases in corporate net lending Corporate sector Government sectorStart year EA 172.7-3.92008 Ireland3-11.9*2007 Greece4-3.72007 Spain8.9-11.22007 Italy1.9-32007 Portugal5.4-5.62008 Table 1: Changes in non-financial corporations and government net lending (% of GDP) Note: Adjustment in net lending since the year at which corporate borrowing was largest. *Excludes banking support. Source: EUROSTAT

9. Effects of corporate deleveraging Table 2: Consequences of corporate balance sheet adjustment t=0t=4 Actual change (2) Average change in entire sample Effect of balance sheet adjustment Number of episodes (A)(B)(C)=(B)-(A)(D)(E)=(C)-(D)(F) Debt / GDP 60.358.4-1.95.2-7.112 Leverage 101.285.3-15.9-1.2-14.712 Liquidity / VA 30.033.43.40.92.510 Investment / VA 26.123.2-2.9-0.2-2.816 Savings / VA 17.222.35.00.44.616 Compensation of employees / VA 60.255.6-4.6-0.9-3.720 Real growth 6.69.9-3.324

10. Large increases in household indebtedness Household debt as % of disposable income

11. Why has household indebtedness risen? Permanent income (or life-cycle) model of consumption and saving relates decisions on savings and borrowings to life-cycle factors. –Savings are typically low or negative during an individual’s early working years and during retirement when income is low. Households save at a higher rate during late working years when income is highest. Real interest rates. Future income expectations. Demographics. A major driver of the rise in indebtedness has been the growth in mortgage debt.

12. Interaction between government and household debt Gross government and household debt % of GDP

13. Interaction between government and household debt Net government and household debt % of GDP

14. Household deleveraging during the current crisis

15. Previous episodes of household deleveraging Household debt as a % of disposable income

16. Growth was key to previous episodes of deleveraging 198919901991199219931994 Finland5.40.1-6.0-3.6-0.93.7 Sweden2.81.0-1.1-1.2-2.13.9 UK2.30.8-1.40.12.24.3 20072008200920102011f2012f Greece4.31.0-2.3-4.4-5.0-2.0 Ireland5.2-3.0-7.0-0.40.41.5 Italy1.5-1.3-5.21.30.60.3 Portugal2.40.0-2.51.3-2.2-1.8 Spain3.60.9-3.7-0.10.81.1 Real GDP growth

17. Policy options Successful deleveraging questionable unless growth is restored in the euro area as a whole. Financial market conditions must be normalised. Interest rate cuts by the ECB. Improved incentives for investment in Germany. Unused structural funds could be spent on targeted wage subsidies in the tradable sector → job creation in the export sector. Structural reforms to facilitate the re-allocation of the work force to the tradable sector. Fiscal consolidation should take into account heavily indebted cohorts. Debt relief, where necessary.