Financial & Sovereign Debt Crises Reinhart & Rogoff

Use Tools for Emerging Markets ? Doubt advanced economies should use emerging market tools since less vulnerable and have policy experience Debt restructuring Higher inflation Capital controls Financial repression R&R: BUT advanced countries have used these tools in the past

Undoing financial repression can lead to crises !! Financial sector growth leads to excesses, crisis follows Period of financial repression

Pessimists Reinhart & Rogoff Warn: Current (large) debt overhang => sub-par growth for > 2 decades. Additional factors: Great increase in government debt Aging society Expanding welfare state R&R: Use emerging market tools !!

External Debt Nation can less flexibly deal with external compared to internal debt

Debt Overhang FIG 3.2 advanced nations’ gov’t debt highest since WWII (ignores local gov’t debt) Emerging nations gov’ts deleveraged FIG 3.4 Upward trend in private sector debt

Debt Reduction DEBT/GDP (measures relative ability to repay). But what’s the danger level ?? To reduce DEBT/GDP Grow GDP (unlikely to be enough) Austerity (will not be enough) Default or restructuring Surprise inflation “Financial repression” comprising: Force domestic banks to lend to gov’t (in most LDCs banks are the only demand for gov’t bonds) Impose interest rate ceilings Restrict international capital flows R&R (2012 JEP) investigate 26 episodes when debt/GDP > 90% Debt overhang episodes averaged 1.2% lower growth than during non-overhang periods Average duration of debt overhang was 23 years

Bank crises (vertical black lines) usually followed by Defaults,restructur ings (yellow areas) Debt build-ups (red line)

Restructuring & repression frequent in the past !! Blue: debt/GDP: when high, Restructuring (yellow) Inflation (purple)

TABLE /21 advanced nations had at least 1 debt restructuring or default Debt reductions have helped cut debt overhang in past : Post-WWI, of 17 countries only Finland repaid all its debt to USA Others’ debt “forgiven” e.g. US reduced France & UK debt/GDP by 25% (US lost 15-16% of GDP) Reinhart & Rogoff: need more debt restructuring

A Repression Cycle? Post-Crisis install capital controls, financial repression and default to cut risk, prevent new crises & keep rates low to aid debt financing When confidence returns, authorities liberalize markets but then banking and currency crises follow…