International Debt Deleveraging Luca Fornaro CREI and Universitat - - PowerPoint PPT Presentation

International Debt Deleveraging

Luca Fornaro CREI and Universitat Pompeu Fabra 12th Macroeconomic Policy Research Workshop Budapest, September 2013

1

Motivating facts: Household debt/GDP

United States Spain Portugal

• Un. Kingdom

Ireland 40 60 80 100 120 Household debt/GDP (percent) 1999 2001 2003 2005 2007 2009 2011

2

Motivating facts: Current account/GDP

Euro core Euro periphery United States Japan United Kingdom

• 6
• 4
• 2

2 4 Current account/GDP (percent) 1999 2001 2003 2005 2007 2009 2011

3

Motivating facts: GDP

Euro core Euro periphery United States Japan United Kingdom 92 94 96 98 100 102 Real GDP (index, 2007=100) 2007 2008 2009 2010 2011 2012

4

Research questions

◮ What happens when a group of financially integrated

countries enters a process of debt deleveraging?

◮ What role does the exchange rate regime play?

5

This paper

◮ Provides a framework for understanding debt deleveraging

in a group of financially integrated countries

◮ Key result: monetary unions are particularly prone to

enter a liquidity trap during deleveraging

6

Overview of the framework

◮ World featuring a continuum of small open economies ◮ Foreign borrowing/lending is used to smooth the impact

• f idiosyncratic productivity shocks on consumption

◮ The deleveraging process is triggered by an unexpected

permanent decrease in the (exogenous) borrowing limit

7

Overview of the results

◮ An unexpected drop in the borrowing limit generates a

fall in the world interest rate

◮ With flexible exchange rates, production shifts toward

high debt countries

◮ In a monetary union with nominal wage rigidities

◮ The fall in the interest rate is amplified ◮ Liquidity trap is associated with deep recession,

especially in high-debt countries

8

Related literature

◮ Exchange rate regime and crises: Cespedes, Chang

and Velasco (2004), Christiano, Gust and Roldos (2004), Gertler, Gilchrist and Natalucci (2007), Schmitt-Grohe and Uribe (2011)

◮ Deleveraging and liquidity traps: Eggertsson and

Krugman (2010), Guerrieri and Lorenzoni (2010), Benigno and Romei (2012)

9

Outline

A model of international deleveraging Deleveraging with flexible wages Deleveraging in a monetary union with nominal wage rigidities The zero lower bound Policy experiments

10

Outline

A model of international deleveraging Deleveraging with flexible wages Deleveraging in a monetary union with nominal wage rigidities The zero lower bound Policy experiments

11

Model

◮ World composed of a continuum of small open economies ◮ Each economy is inhabited by a continuum of measure 1

• f households and by a large number of firms

12

Household

◮ Expected lifetime utility in country i

E0 ∞

• t=0

βtU

• C T

i,t, C N i,t, Li,t

• ◮ Budget constraint

C T

i,t + pN i,tC N i,t + Bi,t+1

Rt = wi,tLi,t + Bi,t + Πi,t

◮ Borrowing constraint

Bi,t+1 ≥ −κ

Optimality conditions 13

Firms

◮ Tradable sector

Y T

i,t = AT i,t

• LT

i,t

αT

◮ AT i,t is a country-specific productivity shock ◮ Non-tradable sector

Y N

i,t = AN

LN

i,t

αN

14

Market clearing

◮ Tradable consumption good

C T

i,t = Y T i,t − Bi,t+1

Rt + Bi,t

◮ Non-tradable consumption good

C N

i,t = Y N i,t ◮ Labor

Li,t = LT

i,t + LN i,t ◮ World market clearing

1 C T

i,t di =

1 Y T

i,t di ⇐

⇒ 1 Bi,t+1 di = 0

15

Some useful definitions

◮ The stock of net foreign assets owned by country i at the

end of period t is NFAi,t = Bi,t+1 Rt

◮ Current account

NFAi,t−NFAi,t−1 = CAi,t = Y T

i,t−C T i,t+Bi,t

• 1 −

1 Rt−1

• 16

Functional forms

◮ Preferences

U

• C T, C N, L
• = C 1−γ

1 − γ − L1+ψ 1 + ψ C =

• C Tω

C N1−ω

◮ Productivity shock

AT

i,t = ρAT i,t−1 + ǫi,t

17

Parameters

Table 1: Parameters (annual) Value Source/Target Risk aversion γ = 4 Standard value Discount factor β = 0.9756 R = 1.025 Frisch elasticity of labor supply 1/ψ = 1 Kimball and Shapiro (2008) Labor share in trad. sector αT = 0.65 Standard value Labor share in non-trad. sector αN = 0.65 Standard value Share of trad. in consumption ω = 0.5 Stockman and Tesar (1995) TFP process σǫ = 0.0194 Benigno and Thoenissen (2008) ρ = 0.84 Initial borrowing limit κ = 0.9 Debt/GDP= 20%

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Policy functions

−0.9 −0.8 −0.7 −0.6 −0.5 −0.02 0.02 0.04

Current account

Wealth at the start of the period: Bt −0.9 −0.8 −0.7 −0.6 −0.5 1.25 1.26 1.27 1.28 1.29 1.3 1.31

Labor

Wealth at the start of the period: Bt High TFP Low TFP

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Distribution of net foreign assets/GDP

−100 −50 50 100 150 200 250 300 0.02 0.04 0.06 0.08 Net foreign assets/GDP Fraction

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Deleveraging shock

◮ Start from steady state with κ = κH ◮ Unexpected permanent drop to κ = κL < κH ◮ I set κL = 0.75κH (in the final steady state world

debt/GDP is 15 percent) graph

21

Outline

A model of international deleveraging Deleveraging with flexible wages Deleveraging in a monetary union with nominal wage rigidities The zero lower bound Policy experiments

22

Transitional dynamics

−1 1 2 3 4 0.6 0.7 0.8 0.9

Borrowing limit

−1 1 2 3 4 18 19 20 21

World debt/GDP

percent −1 1 2 3 4 1 2 3

Interest rate

percent years −1 1 2 3 4 −0.05 0.05 0.1 0.15 0.2

World output

% dev. from initial ss years Tradable good Non-tradable good 23

Impact response across the NFA distribution

−1 −0.5 0.5 1 −10 −5 5 10 15 20th p erc. 50th p erc.

Current account/GDP

change from initial steady state Wealth at the start of the transition: B0 −1 −0.5 0.5 1 −5 5 10 15 20th p erc. 50th p erc.

Output of tradables

% deviation from initial ss Wealth at the start of the transition: B0 B0 < −k ′ −1 −0.5 0.5 1 −10 −5 5 20th p erc. 50th p erc.

Consumption of tradables

% deviation from initial ss Wealth at the start of the transition: B0 −1 −0.5 0.5 1 −10 −5 5 20th p erc. 50th p erc.

Real wage

% deviation from initial ss Wealth at the start of the transition: B0

Current account equation 24

Wage rigidities and the nominal exchange rate

◮ Nominal wages adjust slowly to shocks ◮ Movements in the nominal exchange rate can act as a

substitute for nominal wage flexibility

Equations

Proposition

From the perspective of a single country the flexible wage equilibrium attains the constrained optimum.

25

Outline

A model of international deleveraging Deleveraging with flexible wages Deleveraging in a monetary union with nominal wage rigidities The zero lower bound Policy experiments

26

A monetary union

◮ Budget constraint in terms of currency

P T

t C T i,t + P N i,tC N i,t + Bi,t+1

RN

t

= Wi,tLi,t + Bi,t + Πi,t

◮ Bonds are denominated in units of currency ◮ Borrowing limit

Bi,t+1 P T

t+1

≥ −κ

27

Central bank

◮ There is a single central bank that uses RN as its policy

instrument

◮ Start by considering a central bank that targets zero

inflation in the tradable sector P T

t+1 = P T t

28

Nominal wage rigidities

◮ Nominal wages are fixed in the short run (period 0) ◮ From period t = 1 wages are fully flexible

29

Transitional dynamics in a monetary union

−1 1 2 3 4 0.6 0.7 0.8 0.9

Borrowing limit

−1 1 2 3 4 17 18 19 20 21

World debt/GDP

percent −1 1 2 3 4 −6 −4 −2 2 4

Interest rate

percent years Monetary union

• Flex. wage

−1 1 2 3 4 −0.2 −0.1 0.1

World output

% dev. from initial ss years Tradable good Non-tradable good 30

Impact response across the NFA distribution

−1 −0.5 0.5 1 −10 −5 5 10 15 20th p erc. 50th p erc.

Current account/GDP

change from initial steady state Wealth at the start of the transition: B0 −1 −0.5 0.5 1 −5 5 10 15 20th p erc. 50th p erc.

Output of tradables

% deviation from initial ss Wealth at the start of the transition: B0 B0 < −k ′ −1 −0.5 0.5 1 −30 −25 −20 −15 −10 −5 5 20th p erc. 50th p erc.

Consumption of tradables

% deviation from initial ss Wealth at the start of the transition: B0 −1 −0.5 0.5 1 −20 −15 −10 −5 5 20th p erc. 50th p erc.

Output of non-tradables

% deviation from initial ss Wealth at the start of the transition: B0

Production of non-tradables 31

Outline

A model of international deleveraging Deleveraging with flexible wages Deleveraging in a monetary union with nominal wage rigidities The zero lower bound Policy experiments

32

The zero lower bound

◮ Define ˆ

RN

t

as the nominal interest rate consistent with the inflation target

◮ Now monetary policy is given by RN t = MAX

• ˆ

RN

t , 1

• ◮ During period 0, the price of the tradable good has to fall

to guarantee market clearing

◮ Two effects

◮ Employment in the tradable sector decreases ◮ Fisher’s debt-deflation: the real debt burden increases 33

Transitional dynamics in a liquidity trap

−1 1 2 3 4 0.6 0.7 0.8 0.9

Borrowing limit

−1 1 2 3 4 18 19 20 21

World debt/GDP

percent −1 1 2 3 4 −1 1 2 3

Interest rate

years −1 1 2 3 4 −3 −2 −1 1

World output

% dev. from initial ss years Tradable good Non-tradable good 34

Impact response across the NFA distribution

−1 −0.5 0.5 1 −10 −5 5 10 15 20 20th p erc. 50th p erc.

Current account/GDP

change from initial steady state Wealth at the start of the transition: B0 −1 −0.5 0.5 1 −10 −5 5 10 20th p erc. 50th p erc.

Output of tradables

% deviation from initial ss Wealth at the start of the transition: B0 B0 < −k ′ −1 −0.5 0.5 1 −40 −35 −30 −25 −20 −15 −10 −5 5 20th p erc. 50th p erc.

Consumption of tradables

% deviation from initial ss Wealth at the start of the transition: B0 −1 −0.5 0.5 1 −30 −25 −20 −15 −10 −5 5 20th p erc. 50th p erc.

Output of non-tradables

% deviation from initial ss Wealth at the start of the transition: B0

35

Outline

A model of international deleveraging Deleveraging with flexible wages Deleveraging in a monetary union with nominal wage rigidities The zero lower bound Policy experiments

36

Policy experiments

◮ One period is a quarter ◮ Persistent nominal wage rigidities ◮ Gradual tightening of the borrowing limit

37

Transitional dynamics

−1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 2.4 2.6 2.8 3 3.2

Borrowing limit

−1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 78 80 82 84 86 88

World debt/GDP

percent −1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 5 10 15 20

Real interest rate

percent (annualized) quarters −1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 90 92 94 96 98 100 102

Consumer price index

index (t − 1 = 100) quarters −1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 5 10 15 20 Nominal interest rate percent (annualized) −1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 −8 −6 −4 −2 2

World output

% deviation from initial ss quarters Trad. Non-trad.

38

Changing the inflation target

−1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 78 80 82 84 86 88 90

World debt/GDP

percent −1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 −5 5 10 15 20

Real interest rate

percent (annualized) quarters −1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 90 95 100 105 110

Consumer price index

index (t − 1 = 100) −1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 −5 5 10 15 20 Nominal interest rate percent (annualized) −1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 −8 −6 −4 −2 2

World output - tradables

% deviation from initial ss quarters −1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 −8 −6 −4 −2 2

World output - non-trad.

% deviation from initial ss quarters

• inf. target = 2%
• inf. target = 4%

39

“Soft landing”

−1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 2.4 2.6 2.8 3 3.2

Borrowing limit

−1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 70 75 80 85 90

World debt/GDP

percent −1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 90 95 100 105

Consumer price index

index (t − 1 = 100) quarters −1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 −5 5 10 15 20 Nominal interest rate percent (annualized) −1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 −8 −6 −4 −2 2

World output - tradables

% deviation from initial ss quarters −1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 −8 −6 −4 −2 2

World output - non-trad.

% deviation from initial ss quarters baseline soft landing

40

Conclusion

◮ Main message: monetary unions are particularly prone to

enter a liquidity trap during deleveraging

◮ Other policy tools

◮ Fiscal transfers and debt relief policies (Fornaro 2013) 41

Thank you

42

Household’s optimality conditions

pN

i,t =

UC N

i,t

UC T

i,t

−ULi,t = wi,tUC T

i,t

UC T

i,t

Rt = βEt

• UC T

i,t+1

• + µi,t

Bi,t+1 ≥ −κ, with equality if µi,t > 0,

Back 43

Nominal wage rigidities and the exchange rate

◮ Define Si as country i nominal exchange rate against the

key international currency P T

i,t = Si,tP T t ◮ Normalize P T = 1, firms’ labor demand implies

LT

i,t =

• αTAT

i,t

Si,t Wi,t

• 1

1−αT Back 44

The current account

CAi,t = Y T

i,t − C T i,t + Bi,t

• 1 −

1 Rt−1

• Back

45

Real exchange rate and production of non-tradables

◮ Real exchange rate

P N

i,t = 1 − ω

ω C T

i,t

C N

i,t

P T

t ◮ Equilibrium labor in the non-tradable sector

LN

i,t =

• αNAN P N

i,t

Wi,t

• 1

1−αN Back 46

Motivating facts: Household debt/GDP

United States Spain Portugal

• Un. Kingdom

Ireland 40 60 80 100 120 Household debt/GDP (percent) 1999 2001 2003 2005 2007 2009 2011

47

Motivating facts: Current account/GDP

Euro core Euro periphery United States Japan United Kingdom

• 6
• 4
• 2

2 4 Current account/GDP (percent) 1999 2001 2003 2005 2007 2009 2011

48

Motivating facts: CA deficits and unemployment

AUT BEL FIN FRA DEU GRC IRL ITA JPN NLD PRT ESP GBR USA

• 15
• 10
• 5

5 10 Current account/GDP in 2007

• 5

5 10 15 Change in unemployment rate - 2007/2011

49

Eurozone: net debtors NFA/GDP

• 20
• 15
• 10
• 5

percent 1980 1990 2000 2010 year

Source: data from Milesi-Ferretti and Lane (2009)

Eurozone - net debtors NFA/GDP

Back 50

A model with interest rate spreads

◮ Suppose households in country i are charged the interest

rate Ri,t UC T

i,t = Ri,tβEt

• UC T

i,t+1

• ◮ Assuming the borrowing constraint in the main text

UC T

i,t =

Rt 1 − µi,tRt

UCT

i,t

βEt

• UC T

i,t+1

• ◮ The two models are isomorphic if

Ri,t = Rt 1 − µi,tRt

UCT

i,t

◮ and if the spread Ri,t − Rt is rebated to households in

country i through lump-sum transfers

51