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Transcript of Art on debt
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Index
1. Introduction 2
2. A simple model
2.1. Dynamics 7
2.2. Main features and economic policy 9
3. A model with growth and uncertainty 11
3.1. Dynamics 13
3.2. Economic policy 14
3.3. The long run 20
4. What happened in 2007 21
5. Some empiric results 23
6. Conclusions 24
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1. Introduction
Since 2007 many economists support the use of public spending to
minimize the effects of the crisis. Others argue that it is high time we reduced
public spending to stimulate private investment. The former say that multiplierseffects of public spending can sustain economic activity during recessions,
change expectations, influence positively investment and, in the end, drive the
economy back to previous levels of activity. Some of them even argue that
increasing public spending may even reduce public debt or, at least, its ratio to
GDP since public spending increases GDP and this favors public revenues
growth. Taken to its limit, according to this reasoning, heavily indebted countries
are in this situation because they have spent too little. Among neokeynesians
economists we can cite Paul Krugman or Joseph Stiglitz.
The latter, liberal economists1, argue that increased levels of public
spending and deficit raise the risk premium on interest rates crowding out
investment and deepening the crisis. Among them, the Bundesbank, most
European Central Banks, European Ministries of Finance and, notably, the
German one. They ask for cuts in public spending even at times when it is
almost the sole source of demand, when firms and families have almost ceased
consuming and investing. Their alternatives are the so called structural reforms
and, among them, labor reform, which, in the end, consist almost exclusively in
lowering the cost of labor and, among these costs, firing costs and wages.
However, when sales have almost disappeared, stocks are mounting and firms
1Other liberal economists used to argue that deficits were irrelevant since under the
Ricardian equivalence, private savings would rise by the full amount of the deficit anticipatingthe moment when tax payers will have to pay back the extra debt plus its interests. However,they seem to have disappeared in this crisis from the public debate.
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are losing money, it is far from clear that firms will add to the loses hiring more
labor just because wages or interest rates are lowered.
Despite that some economists on both sides see this controversy in
terms of black and white, many of us believe that sometimes public spending
does more good than harm and sometimes a little bit of austerity is just
unavoidable. If a single, short and deep negative shock hits the economy, public
spending can be a powerful tool but, if the recession lasts more than a few
years, then public spending just cannot be sustained. The central point is,
therefore, how much information do we have about the shock and, if put in
place, when to draw back fiscal stimulus, at what pace and what should be the
roll of monetary policy.
Besides, some economists consider taxes, public spending, deficit anddebt from a different view, more like a game theory problem where
governments act strategically in the political cycle to favor their chances of
being reelected. According to them, as elections get closer public deficit and
debt increase. To avoid this type of behavior some fiscal rules or discipline
should be imposed. They are the last example of a long tradition. We may cite
the following types of rules:
Those focused on the roll of public expenditure in the
management of aggregated demand like the full employment
equilibrated budget or the cyclically equilibrated budget.
Those focused on the sustainability of public finances like the
capability of servicing the debt or paying the interest on debt or the
long term sustainable deficit.
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Both aspects have to be considered. We will not, however, state any
general rule on how deficits and budgets should be fixed. We will just explore
what will happen to GDP and to debt if a given combination of public
expenditure and taxes is chosen at any time. To do that we will have to do
some mathematics related with spending, debt and GDP.
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2.A simple model
The model is quite simple since its equations, except for the last one, are
almost accounting identities, and this last one can be as general as we wish.
Variables should be read as follows: B is the stock of public debt, r is the
interest rate, G is public spending, T is the average tax rate, y is GDP, C is
consumption, I is private investment, XN are net exports and and are
shocks.
= + (1)
= ((1 )) + (,) + + + (2)
= , (3)
Equation (1) says that the increase in public debt in time t equals the
interest paid on the existing debt stock plus the primary (or non financial)
budget deficit. This deficit equals public expenditures minus revenues that we
will call taxes. In some sense, its like the old LM equation that said that
money supply should equal the demand for liquidity but, in this case, written in
terms of debt and interest rates and with no behavior implicit in the equation.
Equation (2) is the usual GDP equation as seen from the demand side
considering also a shock. It is important to notice in this equation that net
exports can play a very important roll sine an increase in net exports can raise
GDP and, therefore, lower interest rates. We can add complexity to this
equation saying that imports depend on income.
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Equation (3) says that interest rates depend on the ratio of public debt to
GDP2 and other variables that we can consider shocks such as the reputation of
the country, its current account deficit, monetary policy, risk aversion level and
so on. After solving equation (1) the model is:
=
+
(
)
()du (1)
= ((1 )) + (,) + + + (2)
= , (3)
We should look closely at equation (1). This equation takes the effects of
shocks, policies or whatever happens in the model in time t to future periods. In
some sense, this equation resumes the consequences of our acts and makesthe model consistent in time. It is also important in the sense that if we divide
both sides by yt we get what can be called the equation of sustainability of
public debt. If GDP is growing almost all deficits are sustainable as long as its
growth rate is greater than the interest rate. If this is the case, interest rates will
go down and we will enter something like a virtuous circle. On the other hand, if
GDP growth rate is smaller than interest rates we have a vicious circle. GDP
growth and interest rates are, therefore, the main variables driving the dynamics
2Some authors find that the debt service ratio to public revenues works better, that is
rB/Ty instead of B/y. To be honest, the evidence is mixed even on whether there is a fiscaleffect on interest rates. Barth et al (1991) surveyed 42 studies of which 17 found apredominately significant, positive effect of deficits on interest rates; 6 found mixed effects;and 19 found predominately insignificant or negative effects. They conclude that Since theavailable evidence on the effects of deficits is mixed, one cannot say with complete confidencethat budget deficits raise interest ratesBut, equally important, one cannot say that they do nothave these effects. Other reviewers of the literature have reached similar conclusions.
Elmendorf and Mankiw (1999) note that Our view is that this literature...is not very informative.Bernheim (1989) writes that it is easy to cite a large number of studies that support anyconceivable position.
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of the economy and there is little public spending can do to cancel their effects
except for a short period of time.
2.1. DynamicsWe will study the dynamics of this model using a simple graphic. In the
vertical axis we have the interest rate and in the horizontal axis we have GDP.
The line = 0 is just the combination of interest rates and GDP that keepsdebt constant, that is, all the
points where there is a primary
surplus just to service the debt. At
the right of this line debt will
decrease and at the left it willincrease. The line = 0 is thelocus of combinations of interest
rate and GDP that leave the latter
unchanged. Above this line
interest rate is too high reducing
investment and diminishing GDP,
below this line the opposite. Both
lines divide our graphic in four
areas. In area I it is clear that
interest rates go up and GDP decreases, the economy enters a vicious circle
where action has to be taken. On the other hand, in area III the economy is in a
virtuous circle.
Area III
= 0
y = 0
< 0 > 0
< 0
> 0
r
Area I
Area IIArea IV
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In areas II and IV things are a little bit more complicated, since there is a
line where
=
and interest rates remain unchanged. This line is given by
equation:
=
=() (4)
Our graphic, therefore, can be redrawn adding a third line, the dotted
line. This new line, the line, = 0, will allow us to redefine our four areasaccording to the dynamics of the system. Above this line interest rate will
increase and below it will decrease.
Lets imagine, now, that
from an initial equilibrium point
there is a shock in the financial
markets that drives interest rates
up. Servicing the debt becomes
more expensive and debt starts
to grow. At the same time
investment falls and GDP starts
to fall, were in area I. A sort of
vicious circle drives interest rates
and debt up and GDP down
since the system is unstable.
Things can get even worse if, in
an attempt to stimulate
aggregate demand and GDP growth, the government increases public
spending. In both cases the system is explosive once it enters area I and theonly thing to do is to use monetary policy to bring down interest rates. In area III
= 0
= 0Area III
= 0
Area IV
Area II
Area I
y
r
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the opposite takes place, if a shock lowers interest rates, GDP will start growing
and interest rates falling in a kind of virtuous circle.
2.2. Main features and economic policyA couple of things should be noticed. First of all, while GDP is basically
stable, interest rate is unstable. The only path that goes back to the equilibrium
point is a horizontal straight line at the equilibrium interest rate. This is so
because we have only the demand side of GDP. There is no technology nor
capital accumulation driven growth. If GDP is static and there is no growth,
deficits tend to grow in an explosive manner if they are not quickly cancelled by
cuts in public spending since in the future there will be more debt servicing. This
will drive interest rates up and deficit will mount. Consequently, debt is more or
less constant in time except for some variations that average zero in the long
run.
Second, we do not have a model to determine the interest rate, we don't
have a LM line nor a money market. Our model determines the risk premium
component of interest rates or, at least, one of the factors that may influence
this premium when, as economist say, all things remain equal. It is very
arguable that risk premia respond to the proportion of debt to GDP and even
more that it does so and not to other things that change with GDP like trade
surplus since imports depend on domestic demand. Anyway, if we want our
model simple enough, some hard to swallow assumptions have to be made.
Next, we will remove some of these hypotheses.
Accordingly, our main suggestion to policy makers living in a world with
no economic growth at all would be don't mess around with the risk premium
since it is quite unstable. Second, if it happens that you are in a middle of a
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financial storm, don't worry, no matter what, times will be harder in the future
than they are right now. But, if we want to do some exercises with the Maths,
find multipliers and so on and give some advice, the main questions would be:
what level of public debt and deficit are sustainable3 and for how long. In this
simple case, debt is constant and deficit is zero, both in the long run.
3
We will say that public debt is sustainable if it grows slower than GDP, that is, if itsproportion to GDP remains constant or decreases in the long run. A deficit path that keepspublic debt sustainable we will say it is a sustainable deficit path.
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3.A model with growth and uncertainty
We will introduce now economic growth. The important thing here is not
where this growth comes from, what really matters is just that the economy
grows. Our model, therefore, becomes:
= + (1)
= (2)
= ((1 )) + (,) + + (3)
= , (4)
After solving equations (1) and (2) this model with deterministic growth
becomes:
= + ( )()du (1)
= (2')
= ((1 )) + (,) + + (3)
= , (4)
From equation 1 we know that any primary deficit is sustainable as long
as it grows at a slower pace than the sum of the rate of growth of GDP minus
the interest rate. In this last crisis, GDP growth became negative or slightly
above zero and interest rates grew since the risk premia went up and monetary
policy didn't compensate. If GDP growth is going to remain low in SouthernEurope and interest rates go up as Germany recovers, Southern European
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countries are going to experience higher risk premia and the situation become
explosive. However, GDP growth is not constant in time; there are shocks that
affect GDP growth and expectations become important. Investors in public debt
will care about whether the government is going to pay back its bonds or not,
that is, to default. One important thing for them is how robust GDP growth and
therefore public revenues are going to be in the near future. We will assumethat interest rates depend on the expected proportion of debt to GDP from time t
onwards, something that depends on past values but also on other information.
We will have to change once again our model and it will become:
= + (1)
= where gt = g(Gt/yt, XNt/yt, Tt, rt, t) (2)
= , (3)
After solving equations (1) and (2) this model with stochastic growth
becomes:
= + ( )()du (1)
= , ,,,
(2')
= , (3)
We will assume there is a lower bound to interest rates, that is, 0 r but
also an upper bound, since in this crisis we have seen that interest rates don't
have to reach the infinite before you have severe restrictions to the amount of
money you can borrow. Therefore, 0 r r. On the other hand, the demand
side of the GDP doesn't affect its total, only its composition, how GDP is
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Area III
= 0
g = 0
< 0 > 0
< 0
> 0
r
Area I
Area IIArea IV
distributed among consumption, public expenditures and so on. To end up with,
if the model is going to reflect real economies we have to introduce some
complexities. We should take into account a lower bound to public spending, G,
and an upper bound to the resources the government can get from the
economy, 0 < T-, < 1, a variable that governments can discretionary change. We
can also take into account a limit to how much governments can borrow in
financial markets and the alternative, not paying in due time governments
suppliers. Investors won't probably wait till debt becomes infinite to stop lending.
There is a ceiling to the debt to GDP ratio as there was one with interest rates
and above it investors presume the country will default, they won't buy bonds,
the government won't be able to renew its borrowing and it will default. Let's call
that ratio d.
3.1. DynamicsIn this case we will
substitute in our first graphic y
by g. In equation (1') we find
that the line that keeps the
interest rate unchanged has apositive slope since it is the line
where the equation +
=
holds. The line where thereal side of the economy is in
equilibrium has a negative
slope since it depends on the
effect of interest rates on
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private investment, that is, =
< 0.
3.2. Economic policyNow, let's tell a few stories. If the government increases public spending,
the year it does so GDP will grow at a faster rate than it would otherwise have,
unemployment will go down, taxes will grow but less than public spending and
deficit will increase. Public debt will also increase and, assuming it grows more
than the economy, Interest rates will also go up. GDP will grow more the closer
the economy is and the greater the sensibility of private investment to GDP
growth and, also, if it is quite rigid to interest rates. Public debt will grow
because of two factors: because interest rates are higher and because we have
a bigger primary deficit. Now, if we don't maintain the fiscal stimulus, GDP will
return to previous levels, that is, will grow at a rate below g, but public debt will
continue to grow and also the interest rate if it is bigger than the rate of growth
of the economy. According to equation (1'), public debt is sustainable in the long
run only if interest rates plus the rate of growth of the primary deficit are less
than the rate of growth of the economy. Therefore, in the long run, primary
deficit has to grow less than the economy, its proportion to GDP decrease in
time and its effect on the economy disappear. In conclusion, fiscal stimuli just
cannot be maintained forever since public debt becomes explosive. Therefore,
we have to use them wisely. What is the measure of our wisdom? It depends
on:
The magnitude of the multiplier effect of G on GDP. It depends on
the crowding out effect or how much private investment is
displaced by G and how close is the economy.
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How much deficit G creates since part of the increase in GDP
goes to the government as taxes. The bigger T the lesser the
multiplier effect of G but also the lesser the deficit generated.
The sensibility of interest rates to the ratio between debt and GDP.
The effect of an increase in expenditure on debt depends, on its
turn, on how effective it is to boost the economy and public
revenues.
As we said above, there is a ceiling to debt to GDP ratio and to
interest rates. The closer the economy is to that point, the lesser
the margin for an expansive fiscal policy its government has. Also,
the bigger the interest rates the faster the economy will approach
d with a given primary deficit path.
Let us now see some examples of all of this. To see how it works let's
assume a baseline scenario where the economy and public expenditures grow
at the same rate (we know this is not
sustainable). The economy will
eventually reach a debt to GDP ratio
that makes investors think the
government won't pay back its bonds.In this case, we have primary
surpluses every year but they are not
enough to avoid the explosive
evolution of public debt since the high
value of interest rates makes
servicing the debt an ever increasing
cost. All key variables evolve as
shown in graphic 1. The interest rate is the variable that shows a more
Graphic 1
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explosive behavior4. In graphic 1 all variables are normalized to 100 to see their
proportional changes. In graphics 2, 3 and 4 we will give the original values.
4
Except for the deficit since it was normalized. We gave 100, like to all other variables,its first value that was zero. Therefore, its first change would be infinite in proportional terms,something that disappears with normalization.
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Now we will see what happens to this baseline scenario if our
government increases government spending by 10% of GDP at time 0 (graphic
5) and compare it with what happened in our first case. First of all, it only takes
8 years for the debt to collapse. GDP and debt grow faster than in the previous
case but debt grows faster than GDP so the ratio increases faster when
Graphic 3 Graphic 4
Graphic 2
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compared with our first case. before the collapse the economy may have been
at full employment, but we have to compare that with the cost of default which
means reducing deficit to zero quite abruptly, graphic 6. In this model, if private
investment is not affected by interest rates and only by GDP, after the collapse
of financial markets GDP will fall but it will always be above, even though
slightly, of what it would otherwise have been without the stimulus of 10% ofGDP in public spenditure (graphic 8).
Graphic 5 Graphic 6
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Graphic 7 Graphic 8
What now if our economy starts from sustainable figures, the rate of
growth of the primary deficit plus the interest rate is less or equal than the rate
of growth of the economy. Now the economy grows at 2%, interest rate is 1%,
public expenditure grows at 1% and initial debt is 38% of GDP. At time 1 GDP
suffers a negative shock of, let's say, 5% of GDP, which causes a fall in GDP,
after the automatic stabilizers come to play, of -3.6%, but at a cost of a public
deficit of almost 7% of GDP. Debt enters an explosive path and the economy
will default, more or less, in time 15 even though we have primary surpluses
from year 13 on. The problem here is that fiscal consolidation comes too late
and in an automatic way. If the multiplier of public spenditures were 1.5 instead
of 0.8 (as supposed initially in the exercise) public debt would have not followed
an explosive path. Assuming this is the correct value, even an initial increase of
public spenditures of around 20% of GDP would have caused only a modest
increase in interest rates in the first period. Therefore, knowing the correct value
of the public spenditure multiplier is of the first importance when it comes to
designing the most suitable economic policy in the face of a negative shock.
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Also, if the rate of growth of the economy is 3% instead of 2%, even with
a low multiplier of 0.8 and a big fiscal stimulus of around 10% of GDP or more
will be sustainable from the point of view of the evolution of the debt even
though with an initial deficit of 12% of GDP in time 1.
3.3. The long runWhile deficits can have favorable effects on economic performance in the
short run, they have unfavorable effects in the long term because of potentially
differing economic situations over different horizons. In the long run, the typical
assumption is that the economy is at full employment and the only way to raise
economic growth is to expand the economy's capacity to produce. By reducing
national savings, deficits hinder that ability. Over shorter horizons, when the
economy is well below full employment, the deficit can boost aggregate demand
and increase the use of existing capacity, thus reducing unemployment.
Also, deficits may increase the aggregate supply. Spending on public
infrastructure increases current deficit but its total net effect depends on
whether its return is bigger or not than the cost of borrowing like in any
investment project, public or private.
.
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4. What happened in 2007
The economy was in area III till 2007 and from then on it entered area I.
Using this framework, lets consider a shock on financial markets that drove
interest rates up, that is, that we had a positive value for the shock t and our
debt curve moves up. First, investment, consumption and GDP fell and
unemployment rose given that monetary policy didnt hold down interest rates.
Since this was not the case,
automatic stabilizers came into play,
public deficit increased and public
debt started accumulating till we the
economy reaches a new
equilibrium. Then, governments
decided to fight back and increase
discretionarily public spending. GDP
fall was mitigated but deficit grew
and public debt accumulated faster
but eventually the economy would
have reached a new equilibrium at
point B. End of the story? We willhave to see, since B is not a stable
point interest raise will keep on rising and governments will have to cut public
spending in a desperate effort to curb deficit and interest rates down. These
cuts will cause further GDP falls and unemployment but the closer we get to r
the bigger the cuts in spending. If r reacts slowly we will have more time and
cuts will be lesser and more spaced in time to cause less harm but if r is very
sensitive to Debt over GDP, drastic action will have to be taken. There is littledoubt so far that if the ECB had acted otherwise and lowered interest rates
A
B
g
r
r
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things would have been different but, is there anything that national
governments deprived of the use of monetary policy can do?
The key point here is whether the effect of public spending on income is
strong enough so that the ratio of public debt to GDP goes up or down. We
have assumed so far the most likely, that it goes up. But, if interest rates are not
very sensitive to the debt to GDP ratio, they move slowly and the economy
recovers, that is, g increases, then the economy may return to the stable
equilibrium point by itself or with little help from a restrictive fiscal policy.
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5. Some empiric results
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6. Conclusions
At the beginning of a crisis, governments need to know if it is going to
last or not. In the first case, they should be cautious when it comes to increase
spending since deficits may grow fast and accumulate causing debt to grow. Ifrisk aversion increases and there is a restrictive monetary policy they may
approach more than wanted dangerous waters where the interest rate starts
walking an explosive path leading to default. On the other hand, if we have just
a one period shock, governments can use public spending to compensate the
shock avoiding unemployment and social pain. However, financial crisis
resulting from a excessive expansion of credit all around the world will likely last
for long periods.
Expansionary monetary policy can help a lot by lowering interest rates
and increasing nominal growth, that is, with inflation reducing the debt to GDP
ratio.