“Europe, You’re Down: Cyclicality and the Sovereign Debt Crisis” REAI International Advisory Board Harvard Faculty Club, Nov. 14, 2012 Jeffrey Frankel Harpel Professor

“You’re Up; You’re Down” Cyclicality and Fiscal Policy: The question “What is the right fiscal policy, Austerity or Stimulus?” is as foolish as the question “Should a driver turn west or east?” It depends where he is in the road. – Sometimes west is the right answer, sometimes east. “The boom, not the slump, is the right time for austerity at the Treasury.” - John Maynard Keynes (1937) Collected Writings

Most experience with sovereign debt problems during our lifetimes arose in developing countries Recycling of petrodollars after – ended in the international debt crisis of 1982 and the Lost Decade of growth in Latin America, Emerging market inflows in 1990s – ended in the currency crashes of the late 1990s in Mexico, East Asia, Russia, Turkey, Argentina…

Most Emerging Market countries learned from the sovereign debt crises of the 1980s & 1990s. But many leaders in advanced economies failed to do so. They thought it could never happen to them. Most notably, leaders of euroland, – even after the periphery countries violated the deficit & debt ceilings of Maastricht and the SGP; – And even after the Greek crisis hit in late 2009 !

But Reinhart & Rogoff remind us: sovereign default is an old story, including among advanced countries – This Time is Different, updated in “From Financial Crash to Debt Crisis,” 2010 Sovereign External Debt: Percent of Countries in Default or Restructuring 50%- Sources: Lindert & Morton (1989), Macdonald (2003), Purcell & Kaufman (1993), Reinhart, Rogoff & Savastano (2003), Suter (1992), and Standard & Poor’s (various years). Notes: Sample size includes all countries, out of a total of sixty six listed in Table 1, that were independent states in the given year 1980 s 1930 s 1870 s 1830 s

Some defaulters, since the Napoleonic Wars Sources: S & P; Kenneth Rogoff & Carmen Reinhart; / Which governments have defaulted ?

Carmen Reinhart & Kenneth Rogoff found a growth threshold in Debt/GDP of 90% MoneyHoney blog, Feb.20, 2010 ‘Growth in a Time of Debt’

8 The historic role reversal Debt levels among rich countries (debt/GDP ratios > 80%) are now more than twice those of emerging markets – and rising rapidly. Some emerging markets have earned credit ratings higher than some so-called advanced countries. Over the last decade some emerging market countries finally developed countercyclical fiscal policies: They took advantage of the boom years – to run primary budget surpluses and cumulate reserves. By 2007, Latin America had reduced its debt to 33% of GDP, – vs. 63 % in the US. – And so were able to respond to global recession of

But weaker in advanced economies. World Economic Outlook, IMF, April 2012 Public finances since 2001 have become much stronger in EMs

Ratio of public debt to GDP among advanced countries is the highest since the end of WW II Source: Carlo Cotarelli “Making Goldilocks Happy,” IMF, Apr. 20, 2012

Country creditworthiness is now inter-shuffled “Advanced” countries (Formerly) “Developing” countries AAA Germany, UKSingapore, Hong Kong AA+ US, France AA BelgiumChile AA-JapanChina A+Korea AMalaysia, South Africa A-Brazil, Thailand, Botswana BBB+Ireland, Italy, Spain BBB-IcelandColombia, India BB+Indonesia, Philippines BBPortugalCosta Rica, Jordan BBurkina Faso SD Greece S&P ratings, Feb.2012 updated 8/2012

After failing to take advantage of the expansion to reduce debt/GDP ratios, Greece and some other European countries are now on unsustainable debt paths -- all the worse from applying austerity at the wrong time.

Spreads for Greece, etc., were near zero, , but then shot up in 2008 and, esp., Market Nighshift Nov. 16, 2011

Quality of fiscal policy-making Fundamentally: Quality of institutions. – This does not mean “tough” rules – like SGP, debt ceiling or BBA – which lack enforceability. – Better would be structural budget targets (Swiss) with forecasts from independent experts (Chile). – One third of developing countries since 2000 have graduated from pro-cyclical spending to countercyclical, – even while US, UK & euro countries have forgotten how to run countercyclical fiscal policy, and instead enact fiscal expansion in booms & contraction after recessions.

15 Procyclical fiscal policy Definition: Governments raise spending or cut taxes in booms; and are then forced to retrench in downturns, thereby exacerbating economic upswings & downswings. E. g., the correlation between spending & GDP was positive. Historically, this has been true in developing countries.

Correlations between Govt. Spending & GDP procyclical G always used to be pro-cyclical for most developing countries. countercyclical Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours” Pro-cyclical spending Counter- cyclical spending }

In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy: Negative correlation of G & GDP. Frankel, Vegh & Vuletin (2012) procyclical countercyclical Correlations between Govt. Spending & GDP

To summarize the fiscal role reversal, Many important emerging markets have, so far this century, achieved: – Lower debt levels than advanced economies; – improved credit ratings; – lower sovereign spreads; and – less procyclical fiscal policies.

Rules and optimism bias in official forecasts Fiscal rules are the current fashion. Do they help? The SGP has utterly failed – Angela Merkel’s fiscal compact may be no better. As such rules have failed in the US: – Gramm-Rudman-Hollings – Debt ceiling legislation – Balanced Budget Amendment, if we had one. Optimism bias in forecasts is worse among the € countries supposedly subject to the budget rules of the SGP, – presumably because official forecasters feel pressure to announce they are on track to meet budget targets even if they are not. – When euro country deficits strayed above the 3% GDP limit, governments would adjust their forecasts, but not their policies.

Blog: Writings by Jeffrey Frankel on fiscal policy: “The Future of the Currency Union,” written Oct. 2012, for Academic Consultants Meeting, The Challenges of the Euro Crisis, Federal Reserve Board “On Graduation from Fiscal Procyclicality,” with C.Végh & G.Vuletin “On Graduation from Fiscal Procyclicality,” Journal of Development Economics, Summarized in "Fiscal Policy in Developing Countries: Escape from Procyclicality," Vox.eu, NBER WP Fiscal Policy in Developing Countries: Escape from Procyclicality NBER WP "Over-optimism in Forecasts by Official Budget Agencies and Its Implications," Oxford Review of Economic Policy Vol.27, Issue 4, 2011, NBER WP 17239; Summary in NBER Digest, Nov.2011.Over-optimism in Forecasts by Official Budget Agencies and Its Implications Oxford Review of Economic PolicyVol.27, Issue 4, 17239SummaryNBER Digest “A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile,” forthcoming, Fiscal Policy and Macroeconomic Performance, Central Bank of Chile WP 604, Jan.2011.A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by ChileCentral Bank of ChileWP 604,Jan. “A Lesson From the South for Fiscal Policy in the US and Other Advanced Countries,” Comparative Economic Studies. 53, no.3, Sept.2011.A Lesson From the South for Fiscal Policy in the US and Other Advanced Countries Comparative Economic Studies “Snake-Oil Tax Cuts,” 2008, EPI, Briefing Paper 221. HKS RWP “Snake-Oil Tax Cuts, EPIBriefing Paper 221HKS RWP “The ECB’s Three Big Mistakes,” VoxEU, May 16, 2011.The ECB’s Three Big MistakesVoxEU "Let Greece Go to the IMF," Jeff Frankel’s blog, Feb.11, 2010.Let Greece Go to the IMF “‘Excessive Deficits’: Sense and Nonsense in the Treaty of Maastricht; Comments on Buiter, Corsetti and Roubini,” Economic Policy, Vol.16,1993. Comments on Buiter, Corsetti and Roubini

Appendices 1) The example of Greek debt – And the euro crisis 2) Sovereign spreads 3) Institutions for countercyclical fiscal policy 4) US debt woes

Appendix 1: The example of Greek debt

The Greek budget deficit never got below the 3% of GDP limit, nor did the debt ever decline toward the 60% limit 23

Even Greece’s primary budget deficit has been far in excess of 3% since Source: IMF, I. Diwan, PED401, Oct. 2011

Optimism bias in official forecasts, continued Fiscal rules are the current fashion. Do they help? Example of failure of fiscal rules – in the presence of official forecast bias The Greek government projected in 2000 that its budget deficit would shrink – below 2% of GDP one year in the future and – below 1% of GDP two years into the future, and – that it would swing to surplus 3 years into the future. The actual deficit: 4-5% of GDP, well above the 3%-of-GDP ceiling.

Even though true Greek budget deficits in most years were far in excess of the supposed limit (3% of GDP), 26 Source: Frankel & Schreger (2011) the official budget forecasts were always rosy. Until, in 2009, the bottom fell out of the budget.

Copyright 2007 Jeffrey Frankel, unless otherwise noted WesternAsset.com Bpblogspot.com ↑ Spreads shot up in 1990s crises, and fell to low levels in next decade.↓ Spreads rose again in Sept.2008 ↑, esp. on $-denominated debt & in E.Europe. World Bank Appendix 2: Sovereign spreads

Sovereign spreads depend on risk perceptions, as reflected in the VIX (option-implied volatility of US stock market) Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, 2011 Risk on Risk off

World Economic Outlook, IMF, April 2012 One indication of improved EM creditworthiness: EM sovereigns used to have to pay higher interest rates than many US corporates (BB), but now pay less.

Appendix 3: Countries with good institutional quality tend to be the ones that have attained countercyclical fiscal policy Copyright 2007 Jeffrey Frankel, unless otherwise noted API Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Frankel, Vegh & Vuletin (2012) procyclical →

Building-in counter-cyclical fiscal policy Chile’s fiscal institutions since st rule – Governments must set a budget target = 0 in 2008 under Pres. Bachelet. = 0 in 2008 under Pres. Bachelet. 2 nd rule – The target is structural: Deficits allowed only to the extent that (1) output falls short of trend, in a recession, or (2) the price of copper is below its trend. 3 rd rule – The trends are projected by 2 panels of independent experts, outside the political process. Result: Chile avoided the pattern of 32 other governments, where forecasts in booms are biased toward over-optimism, which is why Chile ran surpluses in the boom while the U.S. & Europe failed to do so.

Appendix 4: US deficit woes The US has mismanaged its finances as badly as Europe. – The US doesn’t have the excuse of 17 legislatures, – just two deadlocked political parties. It is a long-term problem: – i) Future deficits in “entitlement spending” social security & Medicare. – ii) Current budget deficits since 1981 Steps in 1990s to restore surplus worked, but were reversed in 2001.

The US national debt as a share of GDP Source: CBO, March 2012

Source: “The Procyclicalists: Fiscal Austerity vs. Stimulus,” Jeff Frankel’s blog, July 25th, 2012The Procyclicalists: Fiscal Austerity vs. Stimulus The Procyclicalists: Some US politicians dismiss the need for fiscal discipline during periods when growth is strong, thus adding to the upswing -- only to decide the budget deficit is an urgent problem when growth is weak, thus working to exacerbate the downturn

One political obstacle, above all others One of the two political parties has been dominated by a minority who say fiscal balance is urgent, yet also say it can be done entirely by cutting domestic spending: – They want to cut taxes & raise military spending at the same time as eliminating the deficit, – which is mathematically impossible. Prevents any sort of deal like 1990 – which slowed spending growth & raised taxes during the 1990s.

The game of “Chicken” In the 1955 movie Rebel Without a Cause, whoever jumps out of his car first supposedly “loses” the game. James Dean does; but the other guy miscalculates and goes over the cliff.

The debt-ceiling game of “chicken” In the summer of 2011, “fiscal conservatives” threatened government default if their demands were not met. – The resulting political dysfunction led S&P to downgrade US bonds from AAA to AA. A last-minute solution postponed the deadline to the end of 2012: The Fiscal Cliff: – If no action is taken then, (i) all tax cuts expire, (ii) all discretionary spending is cut drastically ½ domestic, ½ military, – (iii) => the most predictable and needless recession in US history – (iv) the debt ceiling law is violated anyway.