Stochastic Optimal Control, International Finance, and Debt Crises

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1 University Press Scholarship Online You are looking at 1-10 of 16 items for: keywords : external debt Stochastic Optimal Control, International Finance, and Debt Crises Jerome L. Stein Published in print: 2006 Published Online: May 2006 ISBN: eisbn: Item type: book DOI: / This book focuses on the interaction between equilibrium real exchange rates, optimal external debt, endogenous optimal growth, and current account balances in a world of uncertainty. The theoretical parts result from interdisciplinary research between economics and state of the art applied mathematics. From the economic theory and the mathematics of stochastic optimal control, benchmarks are derived for the optimal debt and equilibrium real exchange rate in an environment where both the return on capital and the real rate of interest are stochastic variables. The theoretically derived equilibrium real exchange rate the natural real exchange rate (NATREX) is where the real exchange rate is heading. These benchmarks are applied to answer the following questions: What is a theoretically based empirical measure of a misaligned exchange rate that increases the probability of a significant depreciation or a currency crisis? What is a theoretically based empirical measure of an excess debt that increases the probability of a debt crisis? What is the interaction between an excess debt and a misaligned exchange rate? The theory is applied to evaluate the Euro exchange rate, the exchange rates of the transition economies of Eastern Europe, the sustainability of U.S. current account deficits, and derives warning signals of the Asian crises, defaults, and debt crises in emerging markets. United States current account deficits: A stochastic optimal control analysis 1 Jerome L. Stein in Stochastic Optimal Control, International Finance, and Debt Crises Published in print: 2006 Published Online: May 2006 ISBN: eisbn: DOI: / Page 1 of 6

2 For nearly a quarter of a century, the US has persistently run significant current account deficits that transformed it from the world s largest net creditor to its largest debtor. The stochastic optimal control/dynamic programming approach provides a framework to derive the optimal debt ratio, based upon both objective variables and preferences. The following set of questions are answered: What is a sustainable ratio of external debt/gdp? What are the consequences of an excessive debt? By how much does the dollar need to decline in order to achieve a sustainable current account position for the US and rest of world? The deviation of the actual debt ratio from the derived optimum increases the vulnerability of the economy to external shocks. The NATREX model of the equilibrium real exchange rate Jerome L. Stein in Stochastic Optimal Control, International Finance, and Debt Crises Published in print: 2006 Published Online: May 2006 ISBN: eisbn: DOI: / The NATREX is a model of the equilibrium real exchange rate, which is where the real exchange rate is heading. The NATREX model has two components: the long-run equilibrium real exchange rate and the dynamics of adjustment of the medium-run equilibrium to the long-run equilibrium. In the medium-run equilibrium, the ratio of the external debt/gdp is predetermined, and the real exchange rate is associated with both internal and external balance. The real exchange rate and debt ratio are endogenous variables. In full stock-flow equilibrium, the long run equilibrium real exchange rate and external debt ratio depend upon the vector of time varying fundamentals, which are productivity and thrift in the country relative to the rest of the world. The Dynamics of External Imbalances and Debt Kenneth Dyson in States, Debt, and Power: 'Saints' and 'Sinners' in European History and Integration Published in print: 2014 Published Online: August 2014 ISBN: eisbn: DOI: / acprof:oso/ Page 2 of 6

3 This chapter examines the difficulties in defining excessive external imbalance and external debt. It begins by addressing the issue of original sin, focusing on Austro-Hungary, Greece, and Spain, and the implications of excessive imbalances and debt for state power. It sets these issues in the contexts of the distinctive characteristics of creditordebtor state relations. The chapter shows how states are stress-tested using a series of indicators: current accounts, unit labour costs, inflationrate differentials, domestic savings rates, and net household wealth in the case of external imbalances; gross external debt/gdp ratio, external debt service payments and exports, and foreign-exchange reserves in the case of external debt. The chapter analyses the buffers that states can erect against these types of crisis: export-led growth, size and liquidity of domestic bond market, and foreign-exchange reserves. It concludes by considering external risk management as an imprecise science, stressing the overall importance of private sector and state capacity. From the Boom in Capital Inflows to Financial Traps Roberto Frenkel in Capital Market Liberalization and Development Published in print: 2008 Published Online: May 2008 ISBN: eisbn: DOI: / acprof:oso/ This chapter examines the performance of highly indebted countries from the point of view of their links with the international financial market. Although the more analytical parts of the chapter do not refer specifically to Latin America, it considers the regional emergent markets' experiences as examples which provide historical background. The paths followed by some countries in the globalization process led them to situations of segmented integration. Persistently high risk premiums place a country in a sort of financial trap, with a high interest rate and low growth, leaving it highly vulnerable to contagion and other sources of volatility, and imposing narrow limits to the degrees of freedom on economic policy. The chapter suggests that domestic policy implemented during the process of financial integration account for most of the variation in the situations of the different emergent markets in the early 2000s. Page 3 of 6

4 A Comparative Perspective on Developing Economies Yujiro Hayami and Yoshihisa Godo in Development Economics: From the Poverty to the Wealth of Nations Published in print: 2005 Published Online: October 2005 ISBN: eisbn: DOI: / Aims to develop a bird's eye view on current status and growth potential of developing economies by means of highly condensed international comparative statistics in order to postulate broad hypotheses for the analyses in the subsequent chapters. The data suggest that wide differences in economic growth performance among developing countries are due little to differences in natural resource endowments, but may instead be explained by investment in both physical and human capital. Such broadly defined capital formation depends not so much on the level of per capita income as it does on institutions and policies. Disequilibria and Risk Premia: Argentina s Experience During the 2000s from a Latin American Perspective Gustavo Cañonero and Carlos Winograd in Macroeconomics and Development: Roberto Frenkel and the Economics of Latin America Published in print: 2016 Published Online: September 2016 ISBN: eisbn: Publisher: Columbia University Press DOI: / columbia/ the chapter elaborates on the sources of risk that arise from the interaction of the goods and financial markets by revisiting Frenkel s work on exchange rate and sovereign risk premia. The authors dispute the narrow view that states that a run on the domestic currency or a rising sovereign risk premium are always caused by an increase of the foreign debt or a decline in international reserves. Market disequilibrium dynamics may not only be driven by these factors but also by declining incentives to invest. External Debt, Adjustment, and Growth Delano P. Villanueva and Roberto S. Mariano in Fiscal Policy and Management in East Asia Published in print: 2007 Published Online: February 2013 Publisher: University of Chicago Press Page 4 of 6

5 ISBN: eisbn: DOI: / chicago/ High ratios of external debt to GDP in selected Asian countries have contributed to the initiation, propagation, and severity of the financial and economic crises in recent years, reflecting runaway fiscal deficits and excessive foreign borrowing by the private sector. Using the formal framework proposed by Mariano and Villanueva (2005) and using data from the Philippines, this chapter explores the joint dynamics of external debt, capital accumulation, and growth. After analyzing the links between domestic adjustment policies, foreign borrowing, and growth, it estimates the optimal domestic saving rate that is consistent with maximum real consumption per unit of effective labor in the long run. As a by-product, the chapter also measures the steady-state ratio of net external debt to GDP that is associated with this optimal outcome. It first describes the structure of the open-economy growth model with endogenous technical change and then uses Gross National Disposable Income (GNDI) instead of GDP to determine domestic saving. The chapter also draws some implications for fiscal policy and external debt management. International Health Barry S. Levy and Victor W. Sidel in Social Injustice and Public Health Published in print: 2005 Published Online: September 2009 ISBN: eisbn: DOI: / acprof:oso/ The chapter describes how social injustice leads to profoundly increased rates of illness and premature death in developing countries and discusses both internal factors, such as poverty, discrimination, failure to protect human rights, and external factors, such as high external debt, trade barriers, export of hazardous substances from developed countries, inadequate financial and technical assistance from developed countries, the brain drain, the arms trade, and the high cost of drugs and vaccines needed to treat and prevent serious and widespread diseases. Boxes in the chapter address trafficking, hunger and malnutrition in developing countries, and the import of hazardous substances entering into developing countries. The chapter describes measures to address these problems, including promoting approaches that focus on the poor, promoting and protecting human rights and reducing discrimination, improving health care systems, improving education and health literacy, increasing foreign assistance, promoting representative government and reducing corruption, and promoting sustainable development. Page 5 of 6

6 Government Debt: A Key Role in Financial Intermediation Michael Kumhof and Evan Tanner in Money, Crises, and Transition: Essays in Honor of Guillermo A. Calvo Published in print: 2008 Published Online: August 2013 ISBN: eisbn: Publisher: The MIT Press DOI: / mitpress/ This chapter argues that the reason why policy makers avoid unanticipated levies on government debt is because government debt plays a key role in financial intermediation. Hence, defaulting or inflating it away would be akin to a negative technological shock. To make an empirical case for this argument, the chapter shows that in developing countries (1) government domestic debt is now larger than external debt, and growing relative to external debt; (2) banks voluntarily hold a very large fraction of their assets in domestic government debt; and (3) a deep and stable government bond market is critical for further development of domestic financial markets. In this light, explicit or implicit defaults on government debt would have real costs that would need to be traded off against the benefits of lower distortionary taxation. Page 6 of 6