Economics of Public Policy Lecture 6 The financial and sovereign debt crises. Giovanni Razzu Room: Humms 185a

Transcription

1 Economics of Public Policy Lecture 6 The financial and sovereign debt crises Giovanni Razzu Room: Humms 185a G.Razzu@reading.ac.uk

2 Agenda for today Subprime crisis - historical account/what happened - concepts - evidence/data - solutions Link to sovereign debt crisis - deficits and debt - some theoretical issues - Data and country experiences (US, UK and Euro periphery) - Solutions (US, UK, Euro) Back to Theory - fiscal and monetary policy (liquidity trap) - OCA - interpretation for EURO, US,UK

3 Credit crisis The housing bubble: Increase in house prices, increase in household debt secured on increased house values; Increase in mortgages and increase of profits for Banks; Subprime mortgages to keep the system going on; Key concepts: Leverage - the build up of debt relative to assets or income. Minsky: periods of economic stability leads to rising leverage because everyone becomes complacent about the risk that borrowers might not be able to repay. But this rise in leverage eventually leads to economic instability, preparing the ground for financial and economic crisis.

4 Debt since financial crisis

5 Underlying fundamental reasons Financial industry distorted incentives: bank and investors to take enormous risks without due regard to consequences! 1. Deregulation of banking system, with borrowing and lending restrictions lifted in 80s and 90s: Merging of depository and investment banking Separation of auditing Capital ratios: value of deposits as % of value of assets Emergence of shadow banking Government not letting banks fail: too big to fail policy 2. Political objective: Every American to be able to own a house (American Dream Downpayment Act) 3. Monetary policy: low interest rates on Government bonds

6 Solutions Substantial Government intervention: 1. Public funding to: Cover Banks' losses and avoid bankruptcy Fund social security - unemployment benefits etc Guarantee of deposits 2. Regulation of banking system to curb reckless risk-taking and incentives that drive it: Separation of investment banking from ordinary/high Street banking? Separation of toxic assets/loans New capital requirements However, in reality there has been much more 1 than 2

7 Consequence Spill-over to real economy: depression/recession, deficit and debt. UK GDP at market prices since recession % change from previous period Dealing with public debt: Sovereign debt crisis in Europe Austerity and debt reduction

8 Concepts Government budget: description of spending and financing plans (taxes) Deficit: the excess of spending over net taxes (taxes less transfers) The amount by which government spending exceeds government income during a specified period of time (usually a year). The budget deficit can be split into two key elements: the cyclical deficit this occurs as a result of a downturn in economic activity when tax receipts fall and spending on social security increases. It can be subsequently eliminated by a period of economic growth; and the structural deficit this occurs when government spending exceeds tax receipts. A government can run a structural deficit even if the economy is growing strongly. Consequently, it can only be tackled by reducing government spending or raising taxes. Public sector debt: deficits accumulated over years. Debt rises whenever Government runs deficits, for it needs to add to its borrowing to meet excess expenditure.

9 UK - Fiscal situation 800 Total Managed Expenditure UK, TME bn TME % of GDP

10 UK - Fiscal situation 800 Total Managed Expenditure UK, TME bn TME % GDP

11 UK - Fiscal situation 40 Budget - billion,

12 UK - Fiscal situation Public Sector Net Debt PSND %GDP PSND bn

13 Fiscal situation Red dots: cyclically adjusted primary balance Blue bars: changes in government expenditure Yellow bars: changes in tax revenue Source: IMF Fiscal Monitor, Octber 2012

14 Consequences of deficit and debt Controversial issue! Deficits and debts are bad to the economy and its growth rate: persistent deficits increase debt. Is debt a problem? The burden of debt depends on: - Who owns the debt - Ability to repay debt Ability to repay debt depends: 1. growth of economy; 2. interest rates (borrowing costs)

15 Austerity or fiscal expansion? Two main positions: 1. Austerity: today s deficit is tomorrow s debt; high debt leads to fiscal crisis, high interest rates on bonds, government defaults, financial meltdown again 2. Fiscal expansion: when economies are weak (and monetary policy ineffective) austerity reduces aggregate demand, leading to recession, which lowers GDP and raises the debt/gdp ratio even more

16 Austerity: debt a burden on future generations The present burdens the future? debt now crowds out capital investment and reduces the capital stock available to future generations. Incurring a larger national debt in this generation will burden the next generation if it : Leads to a less productive economy (lower income) in the next generation, or a smaller real capital stock bequeathed and sold to the next generation Debt is a burden if current generation invests less in building capital stock, so if issuance of debt crowds out formation of useful capital.

17 Austerity: Debt a burden on growth If GDP grows at sufficient rates (more than deficit), debt falls as % of GDP, even if same in nominal value. Does debt pose a burden on growth? Reihnart and Rogoff show that: relationship between government debt and real GDP growth is weak for debt/gdp ratios below a threshold of 90 percent of GDP; Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more. High debt lower growth inability to repay debt high interest rates/borrowing costs higher debt higher Debt/GDP ratio and so on

18 Debt/GDP ratio

19 Austerity: Confidence channels? Lower deficit and Debt will increase demand and output: lower interest rates and lower future taxes needed to repay debt. How: Investors, impressed by Government s effort to reduce deficits, revise down expectations about future borrowing and therefore future level of interest rates. L/T interest rates today reflect expectations about future rates, so expectations of lower future rates/borrowing leads to lower rates right now. Lower rates right now leads to higher investment now

20 Austerity: Alesina and Ardagna A&A s argument: depends on how deficits are reduced: If by raising taxes, more likely to witness deep and prolonged recessions If by cutting spending, very small, short-lived, if any, recessions Spending cuts are less costly for economy than tax increases. Need for carefully designed deficit-reduction plans, based on spending cuts and pro-growth policies. However: how relevant is this research to current situation? Cases do not reflect liquidity trap situations!

21 Fiscal expansion When interest rates cannot be reduced further to incentivise investment (i.e. liquidity trap: savings larger than investments), Government spending does not crowd out private investment but gives a place for those excess savings to go. In depressed economy, budget deficits (government spending) do not compete with private sector for funds, but finds a use for those excess private sector savings. If both private and public sectors save (deleverage), economy goes into depression.

22 Government and the Economy Y = C + G + I + (X-M) GDP = Private Consumption Public Spending Investments (Net Exports: Exports less Imports) Government expenditure enters directly the GDP; Government expenditure impacts on I and C Government taxes impact on C and I What is the net impact?

23 Government and the Economy 1. Government enters the economy by purchasing goods and services, which raises output (the increase in G times the multiplier). 2. Government enters the economy by levying taxes, which net of transfers reduces disposable income and therefore output. 3. Government enters the economy through investment in infrastructure as well as expenditure that increases the economy s productive capacity (R&D), therefore increasing output. 4. A contentious issue is whether Government expenditure displace private expenditure, therefore resulting in no overall increase on output: - Multiplier - Ricardian equivalence

24 Multiplier An initial increase in G leads to an increase in output if Supply can respond to increases in Demand (Keynes). If economy at full capacity, Supply cannot increase in response to increased demand: prices will increase and limited if any impact on output (Neoclassical). Evidence: Some consensus that multipliers around 1 or 1.5: a 1% increase in Government spending increases GDP by 1% - 1.5%; Some believe multipliers close to zero or even negative: when public spending goes up, private spending goes down by the same amount. Latest IMF analysis based on multipliers of between 0.9 and 1.7

25 Fiscal expansion Therefore: Government spending does not crowd out private investment when economy affected by lack of demand. Expansionary fiscal policy (when monetary policy ineffective) can speed recovery and reduce the long term impact of lost production. It is austerity that stifle economic output today and damage productive capacity in the future: - If spending cuts on infrastructure and education; - If scarring effect from youth unemployment

26 Review 26 episodes where 100% of debt to GDP ratio was crossed to draw lessons for today: Latest IMF analysis Supportive monetary environment necessary for successful fiscal consolidation (but what when liquidity trap?); Debt reduction larger when fiscal measures are permanent or structural and complemented by measures that support growth

27 Let s take stock! Public debt (therefore deficit and excessive spending) might be detrimental if it crowds out private investment. The size of multiplier is therefore key: if zero, an increase in public spending reduces private spending by same amount. Most evidence suggests multiplier is positive, in particular when economy not at full capacity/employment. When monetary policy ineffective, fiscal expansion keeps demand high and avoids recession. Therefore: Context and circumstances are key: - Is there any room for loose monetary policy? - What is the level of public debt and growth prospects can it be serviced? - But also: can we devalue the currency to make exports cheaper (see EURO case later on)

28 Austerity through mostly spending cuts: UK Red dots: cyclically adjusted primary balance Blue bars: changes in government expenditure Yellow bars: changes in tax revenue

29 UK Test: - What has been the impact on growth so far? - Has private sector investment risen? Has confidence increased with a firm stand on reducing the debt? - What is the impact on debt and deficit overall? - What is the impact on employment?

30 UK Public Sector Net Borrowing since financial crisis PS Net Borrowing GDP% (right scale) PS Net Borrowing billion (left scale) Source: OBR data

31 UK labour market Employment rate (aged 16 to 64), seasonally adjusted Unemployment rate (aged 16+), seasonally adjusted Source:

32 EURO countries: Case Studies: EU Austerity and loose monetary policy but EURO common currency Source: IMF 2012

33 Eurozone risk of default Eurozone one monetary authority (ECB) National Government issue debt in common currency (EURO) Governments have no direct control over EURO Government have liquidity constraints cannot always guarantee liquidity (Euros) to be available to pay out bondholders at maturity of debt.

34 Eurozone risk of default Benefits from default Costs of default C Solvency shock

35 Eurozone risk of default Benefits from default Costs of default C Solvency shock

36 Eurozone risk of default Benefits from default Costs of default D C N Solvency shock

37 Eurozone risk of default Solutions: Major problem arise by Government having a liquidity constraint Increase costs of default how? Entrust role of lender of last resort to ECB it will always provide liquidity needed in the bind market (this is what happened et the end) Consolidating national debt into one common debt (budgetary union)

38 Case Studies: EU Test: - What has been the impact on growth so far? - What is the impact on debt and deficit overall? - What is the impact on employment? - What barriers does a single currency pose?

39 Case Studies: EU Public Sector Debt before and after 2008 crisis, % of GDP Selected EU countries Source: Eurostat

40 Case Studies: EU Unemployment rate since 2008 crisis, seasonally adjusted quarterly average, Selected EU countries, % Source: Eurostat

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42 Case Studies: EU Employment rate (15-64) since 2008 crisis, seasonally adjusted quarterly average, Selected EU countries, % 80.0 Employment rate Source: Eurostat Ireland Greece Spain Italy United Kingdom

43 Case Studies: EU General Government deficit/surplus - % of GDP, Selected EU countries Source: Eurostat

44 Case Studies: EU and UK General Government expenditure - % of GDP, Selected EU countries Source: Eurostat

45 How to use Eurostat online data ained/index.php/statistical_themes

46 Relevant dataset EUROSTAT Portal: Government Finance: Office for Budget Responsibility Fiscal Outlook: IMF Public sector debt stats: pagepk: ~pipk: ~thesitepk: ,00.html HM Treasury Public Finance: ONS

47 Relevant Blogs IMF Olivier Blanchard Paul Krugman Greg Mankiw Simon Wren Lewis Jonathan Portes Brad De Long