1. Sovereign Debt Panel June 6, 2012 Jeffrey Frankel Harpel Professor Institute for Global Law & Policy, Harvard Law School

2. Most experience with sovereign debt problems during our lifetimes arose in developing countries Recycling of petrodollars after 1974 - Recycling of petrodollars after 1974 - ended in the international debt crisis of 1982 - ended in the international debt crisis of 1982 - and the Lost Decade of growth in Latin America, and the Lost Decade of growth in Latin America, until the write-downs of the Brady Plan: 1989-. until the write-downs of the Brady Plan: 1989-. Emerging market inflows in 1990s Emerging market inflows in 1990s ended in the Mexican peso crisis of 1994, ended in the Mexican peso crisis of 1994, East Asia crisis of 1997-98 (private debts), and East Asia crisis of 1997-98 (private debts), and Russia 1998 & Argentina 2001 devaluations & defaults. Russia 1998 & Argentina 2001 devaluations & defaults.

3. 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. They thought it could never happen to them. Most notably, leaders of euroland, Most notably, leaders of euroland, even after the periphery countries violated the deficit & debt ceilings of Maastricht and the SGP; 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 ! And even after the Greek crisis hit in late 2009 !

4. But Reinhart & Rogoff remind us: sovereign default is an old story, including among advanced countries – This Time is Different, updated in 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%- 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

5. Some defaulters, since the Napoleonic War Sources: S & P; Kenneth Rogoff & Carmen Reinhart; http://jongoodwin.com/2010/04/15/die-rechnung / Which governments have defaulted ?

6. Carmen Reinhart & Kenneth Rogoff (‘Growth in a Time of Debt’) famously found a growth threshold in Debt/GDP of 90% MoneyHoney blog, Feb.20, 2010

7. 7 The historic role reversal Debt levels among rich countries (debt/GDP ratios ≈ 80%) are now more than twice those of emerging markets Debt levels among rich countries (debt/GDP ratios ≈ 80%) are now more than twice those of emerging markets and rising rapidly. and rising rapidly. Some emerging markets have earned credit ratings higher than some so-called advanced countries, Some emerging markets have earned credit ratings higher than some so-called advanced countries, and interest rate spreads that are lower.. and interest rate spreads that are lower.. Over the last decade some emerging market countries finally developed countercyclical fiscal policies: Over the last decade some emerging market countries finally developed countercyclical fiscal policies: They took advantage of the boom years 2003-2007 They took advantage of the boom years 2003-2007 to run budget primary surpluses and cumulate reserves. to run budget primary surpluses and cumulate reserves. By 2007, Latin America had reduced its debt to 33% of GDP, By 2007, Latin America had reduced its debt to 33% of GDP, as compared to 63 % in the United States. as compared to 63 % in the United States. And so were able to respond to global recession of 2008-09. And so were able to respond to global recession of 2008-09.

8. But weaker in advanced economies. World Economic Outlook, IMF, April 2012 Public finances since 2001 have become much stronger in EMs

9. 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

10. Country creditworthiness is now inter-shuffled “Advanced” countries (Formerly) “Developing” countries AAA Germany, UKSingapore, Hong Kong AA+ US, France AA BelgiumChile AA-JapanChina A+Korea AMalaysia, South Africa A-Brazil, Thailand, Botswana BBB+Ireland, Italy, Spain BBB-IcelandColombia, India BB+Indonesia, Philippines BBPortugalCosta Rica, Jordan BBurkina Faso SDGreece S&P ratings, Feb.2012 updated 4/25/2012

11. World Economic Outlook, IMF, April 2012 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.

12. 12 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. It’s not just the level of debt/GDP that matters but the risk of getting stuck on an explosive path, with ever-rising debt/GDP but the risk of getting stuck on an explosive path, with ever-rising debt/GDP because of high primary deficit or interest rates (or low growth), because of high primary deficit or interest rates (or low growth), combined with risk of a sudden deterioration combined with risk of a sudden deterioration from a worsening of global financial conditions from a worsening of global financial conditions or a decline in export markets, or a banking crisis. or a decline in export markets, or a banking crisis. Early Warning indicators: Early Warning indicators: composition of capital inflows composition of capital inflows Fx-denominated, ST, bank loans vs. Fx-denominated, ST, bank loans vs. FDI, equity & contracts with automatic adjustment provisions. FDI, equity & contracts with automatic adjustment provisions. Plus real currency overvaluation & fx reserves (for peggers)… Plus real currency overvaluation & fx reserves (for peggers)…

14. Quality of fiscal policy-making Fundamentally: Quality of institutions. Fundamentally: Quality of institutions. This does not mean “tough” rules – like SGP, debt ceiling or BBA – which lack enforceability. 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). 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, 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, even while US, UK & euro countries have forgotten how to run countercyclical fiscal policy, and instead enact fiscal expansion in booms & contraction after recessions. and instead enact fiscal expansion in booms & contraction after recessions.

15. 15 Procyclical fiscal policy Definition: 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. E. g., the correlation between spending & GDP was positive. Historically, this has been true in developing countries Historically, this has been true in developing countries Especially among commodity-producers Especially among commodity-producers and in Latin America. and in Latin America.

16. Correlations between Govt. Spending & GDP 1960-1999 procyclical G always used to be pro-cyclical for most developing countries. countercyclical Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours” Pro-cyclical spending Counter- cyclical spending }

17. In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy: Negative correlation of G & GDP. Frankel, Vegh & Vuletin (2012) procyclical countercyclical Correlations between Govt. Spending & GDP 2000-2009

18. To summarize the fiscal role reversal, Many important emerging markets have, so far this century, achieved: Many important emerging markets have, so far this century, achieved: Lower debt levels than advanced economies; Lower debt levels than advanced economies; improved credit ratings; improved credit ratings; lower sovereign spreads; and lower sovereign spreads; and less procyclical fiscal policies. less procyclical fiscal policies.

19. Rules and optimism bias in official forecasts Fiscal rules are the current fashion. Do they help? Fiscal rules are the current fashion. Do they help? The SGP has utterly failed The SGP has utterly failed The Fiscal Compact will be no better. The Fiscal Compact will be no better. As in the US: As in the US: Gramm-Rudman-Hollings Gramm-Rudman-Hollings Debt ceiling legislation Debt ceiling legislation Balanced Budget Amendment, if we had one. 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, 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. 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. When euro country deficits strayed above the 3% GDP limit, governments would adjust their forecasts, but not their policies.

20. http://ksghome.harvard.edu/~jfrankel/ Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/ http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/ Writings by the speaker on fiscal policy: “On Graduation from Procyclicality,” with C.Végh & G.Vuletin, 2012. NBER WP 17619, Nov. 2011. Summarized in "Fiscal Policy in Developing Countries: Escape from Procyclicality," Vox.eu, June 23, 2011. “On Graduation from Procyclicality,”Nov. 2011Fiscal Policy in Developing Countries: Escape from Procyclicality "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.Over-optimism in Forecasts by Official Budget Agencies and Its Implications Oxford Review of Economic PolicyVol.27, Issue 4, 17239SummaryNBER Digest “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 Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by ChileCentral Bank of ChileWP 604,Jan. “A Lesson From the South for Fiscal Policy in the US and Other Advanced Countries,” Comparative Economic Studies. 53, no.3, Sept.2011. HKS RWP11-014. Short version, India Planning Commission Workshop on Restoring Inclusive Growth, Oct. 2010.A Lesson From the South for Fiscal Policy in the US and Other Advanced Countries Comparative Economic Studies HKS RWP11-014 Short version “Snake-Oil Tax Cuts,” 2008, Economic Policy Institute, Briefing Paper 221. HKS RWP 08-056 “Snake-Oil Tax Cuts, Economic Policy InstituteBriefing Paper 221HKS RWP 08-056 “The ECB’s Three Big Mistakes,” VoxEU, May 16, 2011.The ECB’s Three Big MistakesVoxEU "Let Greece Go to the IMF," Jeff Frankel’s blog, Feb.11, 2010.Let Greece Go to the IMF “‘Excessive Deficits’: Sense and Nonsense in the Treaty of Maastricht; Comments on Buiter, Corsetti and Roubini,” Economic Policy, Vol.16,1993. Comments on Buiter, Corsetti and Roubini

21. Appendices 1) Sovereign spreads 1) Sovereign spreads 2) The example of Greek debt 2) The example of Greek debt And the euro crisis And the euro crisis 3) Institutions for countercyclical fiscal policy 3) Institutions for countercyclical fiscal policy 4) US debt woes 4) US debt woes

22. Copyright 2007 Jeffrey Frankel, unless otherwise noted WesternAsset.com Bpblogspot.com ↑ 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. World Bank Sovereign spreads

23. Sovereign spreads depend on risk perceptions, as reflected in the VIX (option-implied volatility of US stock market) Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, 2011 Risk on Risk off

24. Appendix 2: The example of Greek debt

25. The Greek budget deficit never got below the 3% of GDP limit, nor did the debt ever decline toward the 60% limit 25

26. Even Greece’s primary budget deficit has been far in excess of 3% since 2008 26 Source: IMF, 2011. I. Diwan, PED401, Oct. 2011

27. Optimism bias in official forecasts, continued Fiscal rules are the current fashion. Do they help? Fiscal rules are the current fashion. Do they help? Example of failure of fiscal rules Example of failure of fiscal rules in the presence of official forecast bias in the presence of official forecast bias The Greek government projected in 2000 that its budget deficit would shrink The Greek government projected in 2000 that its budget deficit would shrink below 2% of GDP one year in the future and below 2% of GDP one year in the future and below 1% of GDP two years into the future, and below 1% of GDP two years into the future, and that it would swing to surplus 3 years into the future. 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. The actual deficit: 4-5% of GDP, well above the 3%-of-GDP ceiling.

28. Even though true Greek budget deficits in most years were far in excess of the supposed limit (3% of GDP), 28 Source: Frankel & Schreger (2011) the official budget forecasts were always rosy. Until, in 2009, the bottom fell out of the budget.

29. Appendix 3: Countries with good institutional quality tend to be the ones that have attained countercyclical fiscal policy Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Frankel, Vegh & Vuletin (2012) procyclical →

30. Building-in counter-cyclical fiscal policy Chile’s fiscal institutions since 2000 1 st rule – Governments must set a budget target = 0 in 2008 under Pres. Bachelet. = 0 in 2008 under Pres. Bachelet. 2 nd 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. 3 rd 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.

31. Appendix 4: US deficit woes The US has mismanaged its finances as badly as Europe. The US has mismanaged its finances as badly as Europe. The US doesn’t have the excuse of 17 legislatures, The US doesn’t have the excuse of 17 legislatures, just two deadlocked political parties. just two deadlocked political parties. It is a long-term problem: It is a long-term problem: i) Future deficits in “entitlement spending” i) Future deficits in “entitlement spending” social security & Medicare. social security & Medicare. ii) Current budget deficits since 1981 ii) Current budget deficits since 1981 Steps in 1990s to restore surplus worked, Steps in 1990s to restore surplus worked, but were reversed in 2001. but were reversed in 2001.

32. The US national debt as a share of GDP Source: CBO, March

33. One political obstacle, above all others One of the two political parties is dominated by a minority who say fiscal balance is urgent, yet also say it can be done entirely by cutting domestic spending: One of the two political parties is 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, They want to cut taxes & raise military spending at the same time as eliminating the deficit, which is mathematically impossible. which is mathematically impossible. Prevents any sort of deal like 1990 Prevents any sort of deal like 1990 which slowed spending growth & raised taxes during the 1990s. which slowed spending growth & raised taxes during the 1990s.

34. 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. 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.

35. The debt-ceiling game of “chicken” In the summer of 2011, “fiscal conservatives” recklessly threatened government default if their demands were not met. In the summer of 2011, “fiscal conservatives” recklessly threatened government default if their demands were not met. The resulting political dysfunction led S&P to downgrade US bonds from AAA to AA. 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: A last-minute solution postponed the deadline to the end of 2012: If no action is taken then, (i) all tax cuts expire, (ii) all discretionary spending is cut drastically, & (iii) the debt ceiling law is probably violated anyway. If no action is taken then, (i) all tax cuts expire, (ii) all discretionary spending is cut drastically, & (iii) the debt ceiling law is probably violated anyway. I.e., a return of the stand-off: I.e., a return of the stand-off: => Danger of recession and default ! => Danger of recession and default !