Fiscal Sustainability: What Makes the Euro Area

Fiscal Sustainability: What Makes the Euro Area Different? Eric M. Leeper Indiana University Griswold Center for Economic Policy Studies Princeton University October 2016

What’s Up With Government Debt? I

It’s hard to be conscious during the past 8 years and not notice that government debt is much in the news I

The U.S. & U.K. engaging in fiscal austerity now (but the serious problems loom in future)

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Everyone claims Japanese fiscal policy is unsustainable now, but just announced new stimulus

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But the Eurozone is the poster child I I

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severe austerity even in face of recession sovereign debt crisis triggered a second recession

To get beyond the panic & politics, we need some understanding of government debt I I I

what it does how it gets valued what the consequences of rapid debt growth might be

Government Debt: Some Background I

Some roles that debt plays 1. It is (usually) a safe store of value I

agents put saving into bonds to smooth their consumption in the face of volatile income

2. It permits government to smooth taxes & spending I I

avoids introducing an additional source of instability serves as a shock absorber

3. It provides liquidity/collateral I I

can convert treasuries to cash at low cost important source of backing for repurchase agreements & other credit transactions

4. It is a form of foreign reserves I

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use treasuries to acquire foreign currency for exchange rate interventions (South Korea) use treasuries to channel private saving (China)

Roles 3 & 4 typically ignored in our analyses

Two Kinds of Government Debt I

Distinction between real & nominal debt is critical

1. Real debt: denominated in “goods” I

arises whenever debt is in units whose quantity the government cannot control I I I

indexed to inflation; foreign currency; gold; eggplant U.S. about 10%; U.K. 15–20% of total debt indexed debt is like debt under the Gold Standard, where governments did not control the price level

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a claim to goods in the future

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government must acquire those goods to honor obligations

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can acquire goods through taxes or money creation (seigniorage)

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if it cannot acquire the goods, default only option

Two Kinds of Government Debt 2. Nominal debt: denominated in home currency (“dollars”) I

arises whenever debt is in units whose supply the government can control I

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vast majority of government debt is of this kind

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a claim to “dollars” in the future

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government need not be able to acquire goods

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it can print new “dollars” to reduce market value of debt (“dollars” can be new debt instruments—not necessarily currency)

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default less likely

This distinction carries important policy implications

Two Kinds of Government Debt I

E.A. countries don’t control their monetary policy I

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to each country, debt in euros is real debt

Default on real debt more likely: euro rates embed default premium Real Greece Italy Spain Germany Nominal Japan U.K. U.S.

Debt/GDP

10-year yield

159 123 85 80

22.5 5.5 5.9 1.5

237 86 102

0.8 1.9 1.8

General government debt as percentage of GDP & 10-year government bond yield in 2012. Sources: ECB, Eurostat, IMF

15

20

European Yield Spreads: Great Convergence

Greece Italy

0

5

10

Spain Ireland Portugal

1992

1994

1996

1998

2000

2002

2004

2006

2008

10-year government bond yields over German bund. Source: European Central Bank

Debt/GDP Greece Ireland Italy Portugal Spain

2010 148 92 119 94 62

2011 170 106 121 108 69

2012 157 118 123 124 84

0

10

20

30

European Yield Spreads: Great Divergence

2006

2008

2010

2012

2014

2016

10-year government bond yields over German bund. Source: European Central Bank

Real Debt Valuation I

Government debt is like any asset I

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value depends on expected “cash flows,” discounted back to present

Primary surpluses are the cash flows I

revenues in excess of non-interest spending are the “goods” that back debt ∞

X 1 Bt−1 = Et St+k rt,t+k Pt k=0 Bt−1 : debt held by private sector at beginning of t Pt : price level independent of fiscal policy rt,t+k : real discount rate between periods t and t + k St+k : real primary surplus in period t + k Et : expectations formed at time t

Real Debt Valuation: Some Observations ∞

X 1 Bt−1 = Et St+k rt,t+k Pt k=0 1. Debt valuation is forward looking 2. Higher debt requires higher discounted surpluses 3. Higher surpluses—more backing—can support more real claims to goods & higher debt 4. Higher discount factors—lower real discount rates—permit given surpluses to support higher real claims 5. Nominal variables—like the price level—cannot adjust to FP 6. Individual countries in Euro Area effectively issue real debt I

Pt beyond individual countries’ control

Real Debt & Default: Case of the Euro Area I

Every country faces a fiscal limit I

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point at which—for economic or political reasons—country can no longer raise surpluses to finance debt to quantify fiscal limit need country-specific details I I

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elasticities of private behavior citizen’s tolerance for taxes & demand for public goods evolution of demographics economy’s growth potential elected officials’ discount rates expected future policy choices

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As a country’s debt approaches its fiscal limit, probability of default rises

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I’ll illustrate how the fiscal limit can help us think about sovereign risk with real debt

A Simple Illustration of the Fiscal Limit I

A single type of household/worker I I

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buys consumption goods & bonds supplies labor which is transformed into goods using a technology with random productivity seeks to smooth consumption

The government I I

levies labor income taxes & purchases goods provides transfers according to 2 transfer regimes I I

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“stationary:” transfers/GDP does not grow “explosive:” transfers/GDP grow (reflects aging population)

Growing transfers are financed by new debt & higher taxes Maximum revenues occur at peak of Laffer curve

Model-Based Laffer Curves 0.5

Revenues/GDP

0.4

0.3

0.2

0.1

Baseline High labor elasticity Tax evasion

0 0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

Labor Tax Rate

Position of Laffer curve depends on private behavior Author’s calculations

1

Modeling the Fiscal Limit I

Define the fiscal limit as present value of maximum primary surpluses

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Maximum surpluses arise when I

revenues at their maximum level, given shocks

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expenditures at their minimum level, given shocks

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Of course, other definitions are possible

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Fiscal limit can embody political economy dynamics

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Use the fiscal limit model to price risk

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Illustration that follows calibrates model to Greek data

Features of the Fiscal Limit Fiscal limit answers: “given the economic environment, what is the distribution of government debt that can be supported?” I

uncertain: a probability distribution

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forward-looking—about expected policies & their credibility

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depends on 1. private behavior 2. policy behavior 3. fundamental shocks to the economy

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Fiscal limit distribution emerges from the distribution of expected present value of maximum primary surpluses

Shocks & Policies Fiscal Limit Distribution and Productivity

Fiscal Limit Distribution and Transfers Regime 1

low average

0.5

0 0.5

1

1.5

high

2

2.5

Probability

Probability

1

unstable transfers

0 0.5

3

25

low

15

high

average

10 5 0 0.5

1

1.5

2

Debt−GDP

2.5

1

1.5

2

2.5

3

Debt−GDP Risk Premia and Transfers Regime Percentage Points

Percentage Points

Debt−GDP Risk Premia and Productivity 20

stable transfers

0.5

3

25 20

unstable transfers

15

stable transfers

10 5 0 0.5

1

1.5

2

2.5

Debt−GDP

Fiscal limit CDF computed using peak of labor Laffer curve, constant government purchases, current transfers regime. Vertical line at 170%. Source: Bi & Leeper (2012) I

Low (High) Productivity Can Reduce (Raise) Country’s Sustainable Debt Level

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Unstable (Stable) Growth in Transfers Can Reduce (Raise) Country’s Sustainable Debt Level

3

Uses of the Fiscal Limit I

Focuses attention on distance between current debt & fiscal limit I

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To gauge a “safe” level of debt I

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Slovakia’s Council for Budget Responsibility decided on 40% debt-GDP, rather than Maastricht’s 60%

To evaluate sovereign risk consequences of reforms I

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current debt alone not a sufficient statistic

if people believe pension reforms permanent or government will crack down on tax evasion, limit shifts out to make debt less risky

IMF & ECB now applying fiscal limit concept I I

integrating fiscal limit with monetary policy to be used as a basis for policy advice

What If Debt is Nominal? I

Analysis of sovereign default treated debt as real ∞

X 1 Bt−1 St+k = Et rt,t+k Pt k=0 I

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all adjustments must occur through Et PV(S)

Nominal debt brings the price level, Pt , into play ∞

X 1 Qt Bt−1 = Et St+k Pt r t,t+k k=0 I I I

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Qt is price of bond portfolio in period t, Bt−1 is given (unaffected by news at t) but Pt & Qt are not: can change with news about current & future surpluses Pt converts the dollar-denominated debt into units of goods, as in Et PV(S)

What If Debt is Nominal? ∞

X 1 Qt Bt−1 = Et St+k Pt rt,t+k k=0 I I I

Suppose the economy is near its fiscal limit This means the value of debt is reaching its maximum If nominal debt continues to grow, but Et PV(S) is unchanged. . . I I I

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the dollar value of debt rises but the real value is fixed by Et PV(S) price level must rise or bond price must fall to keep real value of debt consistent with future surpluses

Raises the possibility that Pt might be determined by fiscal requirements I I

this is heresy especially for monetarists & new Keynesians

What If Debt is Nominal? ∞

X 1 Qt Bt−1 = Et St+k Pt r t,t+k k=0 I

Suppose government cuts taxes & promises never to raise them I

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households feel wealthier & seek to raise consumption they reduce current bond holdings & increase demand for goods higher demand raises dollar-price of goods Pt rises/Qt falls until equilibrium re-established split between current & future inflation determined by monetary policy

These are unbacked fiscal expansions

A Fiscal Straightjacket I

In the Euro Area, when a government issues debt, it has no alternative but to raise surpluses or default I

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This goes a long way toward explaining the prevalence of sovereign debt crisis in. . . I I I

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without coordinated fiscal actions, revaluation of debt through price-level adjustments is impossible

Europe today countries that issue foreign-currency linked debt countries on metallic standards

One option available to real-debt issuers who control their monetary policy (not Eurozone members) I I

print money to generate seigniorage revenues but seigniorage raises real resources, so it is another form of “real backing” for debt

E.A.

0

-1

0

2

1

2

4

3

U.K.

4

6

Inflation & Policy Rates in Major Economies

2012

2014

2016

2010

2012

2014

2016

Japan

-4

-2

0

-2

0

2

2

4

U.S.

2008 4

2010

6

2008

2008

2010

2012

2014

2016

2008

2010

2012

Interest-rate policies not responding strongly to inflation

2014

2016

What Japan is Doing I

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Since 1993: inflation averaged 0.21%, GDP growth averaged 0.84%, government debt has grown from 75% to 230% of GDP Prime minister Abe’s three arrows: monetary expansion, fiscal stimulus, structural reform Japan raised consumption tax: from 3% to 5% in 1997; from 5% to 8% in April 2014 Meanwhile, the IMF is applying pressure: I

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“A post–2015 fiscal consolidation plan is urgently needed. . . . Options. . . include gradually increasing the consumption tax to at least 15 percent. . . .”

Finance minister Aso has committed to raise taxes again in 2017 (but Abe sending different signal now) Japan has been choosing to treat nominal debt as real debt

4

Confused Priorities: Japan Consumption Tax Increased from 5% to 8%

0

2

Consumption Growth

-4

-2

GDP Growth

2012

2013

2014

2015

1

2

3

4

2011

CPI Inflation 0

Consumption Tax Increased from 5% to 8%

-1

Core CPI Inflation 2011

2012

2013

2014

2015

What Switzerland & Sweden Are Doing I

These two countries have had serious fiscal rules for 15 or more years I

“serious” means they actually follow them

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Switzerland: debt brake

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Sweden: net lending target

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Do these fiscal rules provide appropriate fiscal backing for monetary policy? I I

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do they eliminate wealth effects of monetary policy? how do they anchor fiscal expectations?

Their experiences raise some questions

45

50

55

What Switzerland & Sweden Are Doing Swiss government debt (% GDP)

30

35

40

Swedish government debt (% GDP)

2000

2002

2004

2006

2008

2010

2012

2014

2016

4

Negative policy rates adopted

2

Target

0

Swedish inflation

-2

Swiss inflation 2000

2002

2004

2006

2008

2010

2012

2014

2016

Source: Statistics Sweden, Swedish National Debt Office, & Swiss National Bank

Yield on Gov't Bonds 0

.5

1

Swiss Yield Curve (Zero Coupon Bonds)

Nov2014

-.5

Jun2015 May2016

-1

Feb2016 0

2

4 6 Years to Maturity

Source: Global Insight

8

10

Yield on Gov't Bonds -.2 0 .2 .4

.6

.8

Swedish Yield Curve (Zero Coupon Bonds)

Jan2015

-.4

Feb2015

-.6

Sep2015 May2016 0

2

4 6 Years to Maturity

Source: Riksbank

8

10

What Major Economies Could Do I

Continue along same path: do more of what hasn’t worked I

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Or elevate fiscal policy to status of monetary policy I

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a mix of super-low interest rates & fiscal austerity take fiscal actions to address below-target inflation & weak growth announce an unbacked fiscal expansion coupled with pegged interest rates

With recent history of fiscal expansion followed closely by austerity. . . I

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it will be hard to convince people you’re really going to do something new Sims calls current beliefs “hyper-Ricardian” if people aren’t convinced, could get higher debt with no economic stimulus

What Major Economies Could Do I I

Employ fiscal forward guidance Announce a plan to run primary deficits until inflation picks up I

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if government stuck to this plan, people will realize their nominal assets will lose value this will induce them to spend those assets, increasing aggregate demand if prices do not immediately adjust fully, real activity will rise inflation will gradually increase

Critical element: growth in nominal debt need not threaten sustainability I I

its real value will adjust to expected surpluses public & policymakers need to understand there is no necessary conflict between fiscal stimulus & fiscal sustainability

What Major Economies Could Do I

I can already hear the cries of “hyperinflation” I

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also heard these cries in 1930s during Great Depression & in past 7 years

But there are only two ways that can arise 1. Central banks print money to buy debt 2. Central banks try to fight the inflation with higher interest rates

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Given history, I believe we can trust that (1) won’t happen

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Given history, we cannot be assured (2) won’t happen I

Brazil did this in the late ’80s/early ’90s

Brazil Fought Inflation With Higher Interest Rates Brazilian Annual Consumer Price Inflation 3000

2500

2000

1500

1000

500

0

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

Inflation Rate (annualized). Source: IBGE

2009

2011

2013

2015

Making Unbacked Fiscal Expansion Work I

Bad outcomes—excessive growth in value of debt and/or too much inflation—stem from monetary policy reacting inappropriately I

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All monetary policy need do is continue what it has been doing—pegging interest rates I

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central bank can neither aggressively fight the fiscal inflation nor finance the debt by creating seigniorage

relinquish inflation control to fiscal policy (at least temporarily)

And fiscal authorities cannot backtrack when they see nominal debt growing I

this is exactly what needs to happen to raise real activity & inflation

Historical Precedent I

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Unbacked fiscal expansion lay behind recovery from depression in 1933 After three years of deflation & high unemployment. . . I I

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FDR committed to reflate the economy left gold standard, converting effectively real debt to nominal debt adopted the policy rule: run “emergency” deficits financed by nominal debt until price level rises

FDR eventually caved in to same concerns we hear today about the need to ensure the credit-worthiness of the government & fears of inflation I

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tax increases & spending cuts in 1937, together with Fed policy, produced the sharpest decline in industrial production on record in August 1937 recovery was incomplete: P didn’t return to 1920s level until after WWII

Nominal Debt More Than Doubled Gross Nominal Debt

50 Par Value Market Value

45

40

35

30

25

20

15

10 1920

1922

1924

1926

1928

1930

1932

1934

1936

Source: Hall & Sargent, authors’ calculations

1938

1940

Debt-GNP Stable Gross Debt as Percent of GNP

50

45

40

35

30

25

20 Par Value Market Value

15

10 1920

1922

1924

1926

1928

1930

1932

1934

1936

Source: Hall & Sargent, authors’ calculations

1938

1940

What the Euro Area Could Do I

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Create a mechanism for unbacked fiscal expansions to work Eurobonds: euro-denominated bonds issued by a Eurozone entity I

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But Eurobonds are off the table I

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entity needs some (small) taxing capacity to back bonds could buy sovereign bonds with Eurobonds real value of Eurobonds depends on euro-wide price level arguments against them stem from treating them as real debt (German fears of paying the bills)

Even Draghi is expressing frustration: “Fiscal policies should support the economic recovery” (15 April 2016)

´ Going Beyond the Cliches I

´ Fiscal policy discourse is peppered with cliches, misinformation, & mixed messages

1. IMF: Fiscal actions should be “timely, targeted, and temporary.” 2. Trichet: “It is an error to think that fiscal austerity is a threat to growth and job creation.” 3. Obama: “I will cut the deficit in half by the end of my first term.” 4. Dombrovskis: Fiscal policy cannot commit to future actions. 5. IMF: “Countries. . . should pursue growth-friendly fiscal rebalancing.” I

These amount to choosing to wear a fiscal straightjacket

Keynes Would Approve I

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My proposal simply integrates Keynes’s reasoning with intertemporal equilibrium An unbacked fiscal expansions is pure Keynesian logic: I

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you can stimulate aggregate demand by encouraging people to shed nominal assets in favor of goods

Today we have the “divine coincidence” of seeking both higher inflation & stable debt-GDP Just as countries were free to leave the gold standard in Keynes’s day. . . I

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they are free today to exploit the latitude that nominal debt offers to paraphrase JMK: “we must not allow policymakers to put us back in the real debt cage where we have been pining our hearts out all these years.”