The Debt Challenge in Europe. Alan Ahearne and Guntram Wolff October 2011

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1 The Debt Challenge in Europe Alan Ahearne and Guntram Wolff October 2011

2 Outline The challenge: debt overhang and price adjustment. Large increase in private debt prior to the crisis. Balance-sheet adjustments underway. Examine previous experiences with corporate and household deleveraging. Options for policymakers.

3 Adjustment mechanisms in EMU Membership of euro imposes constraints on macroeconomic policy. Smooth economic adjustment depends crucially on the adjustment of intra-area area real exchange rates and factor mobility (European Commission, 2006 and 2008). Competitiveness channel (EC, 2008; Honohan and Lane, 2003). Real interest rate channel (Walters critique). Factor mobility and Optimum Currency Areas (Mundell, 1961; McKinnon, 1963; and Kenen, 1969).

4 Competitiveness channel versus real interest rate channel The competitiveness channel is expected to outweigh the real interest rate channel over the longer haul. (European Commission, 2006). What is lost when inflation is above the average is much greater than What is lost when inflation is above the average is much greater than what you could theoretically gain with a lower level of real rates. This is very important (Jean-Claude Trichet, 2006).

5 But what about debt? Interaction between public debt and private debt. Large-scale fiscal consolidation reduce income financial distress and banking problems further depress economic growth (Eggertsson and Krugman, 2010). Interaction between needed improvements in competitiveness and high levels of private indebtedness. Depreciation of the real exchange rate through cuts in nominal wage rates and prices eventually boosts incomes. But there s a timing issue. (Fisher, 1933). Labour mobility and mortgage debt.

6 High debt levels in crisis countries Figure 1: Net external financial assets as % of GDP (2009) Figure 2: Net assets in the different domestic sectors as % of GDP (2009) % GDP Ireland Greece Portugal Spain Italy Ireland Greece Spain Italy Non financial corpora ons Financial corpora ons General government Source: EUROSTAT Source: EUROSTAT Portugal Household and NPISH

7 Significant competitiveness adjustments required

8 Fiscal deficits have offset increases in corporate net lending Table 1: Changes in non-financial corporations and government net lending (% of GDP) Corporate sector Government sector Start year EA Ireland * 2007 Greece Spain Italy Portugal Note: Adjustment in net lending since the year at which corporate borrowing was largest. *Excludes banking support. Source: EUROSTAT

9 Effects of corporate deleveraging Table 2: Consequences of corporate balance sheet adjustment t=0 t=4 Actual change (2) Average change in entire sample Effect of balance sheet adjustment Number of episodes (A) (B) (C)=(B) (A) (D) (E)=(C) (D) (F) Debt / GDP Leverage Liquidity / VA Investment / VA Savings / VA Compensation of employees / VA Real growth

10 United Kingdom Switzerland* Large increases in household indebtedness Household debt as % of disposable income Sw Sweden Spain* Austria Belgium Denmark Euro area Finland France Germany Ireland* Italy Net etherlands* Norway* Portugal

11 Why has household indebtedness risen? Permanent income (or life-cycle) model of consumption and saving relates decisions on savings and borrowings to life-cycle factors. Savings are typically low or negative during an individual s early working years and during retirement when income is low. Households save at a higher rate during late working years when income is highest. Real interest rates. Future income expectations. Demographics. A major driver of the rise in indebtedness has been the growth in mortgage debt.

12 Interaction between government and household debt 140 Gross government and household debt % of GDP Ireland Portugal Ho ouseholds' gross debt Spain Euro area France Germany Belgium Italy Greece Government gross debt

13 Interaction between government and household debt Net government and household debt % of GDP Ireland Spain Househ holds' net debt Germany Euro area France Portugal Italy -200 Belgium -250 Government net debt

14 Household deleveraging during the current crisis Table 3: Household debt, (% of disposable income) Austria Belgium Denmark Euro area Finland France Germany Ireland Italy Netherlands Norway n.a. Portugal Spain Sweden Switzerland n.a. U.K

15 Previous episodes of household deleveraging Household debt as a % of disposable income Finland Sweden UK

16 Growth was key to previous episodes of deleveraging Real GDP growth Finland Sweden UK f 2012f Greece Ireland Italy Portugal Spain

17 Policy options Successfuldeleveraging questionable unless growth isrestored in the euro area as a whole. Financial market conditions must be normalised. Interest rate cuts by the ECB. Improved incentives for investment in Germany. Unused structural funds could be spent on targeted wage subsidies in the tradable sector job creation in the export sector. Structural reforms to facilitate the re allocation of the work force to the tradable sector. Fiscal consolidation should take into account heavily indebted cohorts. Debt relief, where necessary.

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