the debt challenge in europe alan ahearne and guntram wolff october 2011
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The Debt Challenge in Europe
Alan Ahearne and Guntram Wolff
October 2011
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.
Adjustment mechanisms in EMU
• Membership of euro imposes constraints on macroeconomic policy.
• Smooth economic adjustment depends crucially on the adjustment of intra-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).
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 you could theoretically gain with a lower level of real rates. This is very important” (Jean-Claude Trichet, 2006).
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.
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)
Source: EUROSTAT Source: EUROSTAT
Significant competitiveness adjustments required
Fiscal deficits have offset increases in corporate net lending
Corporate sectorGovernmentsector Start year
EA 17 2.7 -3.9 2008Ireland 3 -11.9* 2007Greece 4 -3.7 2007Spain 8.9 -11.2 2007Italy 1.9 -3 2007Portugal 5.4 -5.6 2008
Table 1: Changes in non-financial
corporations and government net
lending
(% of GDP)
Note: Adjustment in net lending since the year at which corporate borrowing was largest. *Excludes banking
support.
Source: EUROSTAT
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 60.3 58.4 -1.9 5.2 -7.1 12
Leverage 101.2 85.3 -15.9 -1.2 -14.7 12
Liquidity / VA 30.0 33.4 3.4 0.9 2.5 10
Investment / VA 26.1 23.2 -2.9 -0.2 -2.8 16
Savings / VA 17.2 22.3 5.0 0.4 4.6 16
Compensation of employees / VA
60.2 55.6 -4.6 -0.9 -3.7 20
Real growth
6.6 9.9 -3.3 24
Large increases in household indebtedness
0
50
100
150
200
250
300
1999
2009
Household debt as % of disposable income
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.
Interaction between government and household debt
Belgium
France
Germany
Greece
Ireland
Italy
Portugal
Spain
Euro area
0
20
40
60
80
100
120
140
0 20 40 60 80 100 120 140 160
Government gross debt
Ho
us
eh
old
s' g
ros
s d
eb
t
Gross government and household debt
% of GDP
Interaction between government and household debt
Belgium
FranceGermany
Ireland
Italy
Portugal
Spain
Euro area
-250
-200
-150
-100
-50
0
0 20 40 60 80 100 120
Government net debt
Ho
use
ho
lds'
net
deb
t
Net government and household debt
% of GDP
Household deleveraging during the current crisis
Table 3: Household debt, 2007-2009 (% of
disposable income)
2007 2008 2009 Austria 86 87 87 Belgium 77 79 83 Denmark 255 262 275 Euro area 94 95 97 Finland 97 98 101 France 73 76 77 Germany 93 89 89 Ireland 194 198 199 Italy 57 57 61 Netherlands 222 230 241 Norway 177 177 n.a. Portugal 128 129 131 Spain 130 127 125 Sweden 131 133 140 Switzerland 170 168 n.a. U.K. 152 153 149
Previous episodes of household deleveraging
40.0
60.0
80.0
100.0
120.0
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Finland
Sweden
UK
Household debt as a % of disposable income
Growth was key to previous episodes of deleveraging
1989 1990 1991 1992 1993 1994
Finland 5.4 0.1 -6.0 -3.6 -0.9 3.7
Sweden 2.8 1.0 -1.1 -1.2 -2.1 3.9
UK 2.3 0.8 -1.4 0.1 2.2 4.3
2007 2008 2009 2010 2011f 2012f
Greece 4.3 1.0 -2.3 -4.4 -5.0 -2.0
Ireland 5.2 -3.0 -7.0 -0.4 0.4 1.5
Italy 1.5 -1.3 -5.2 1.3 0.6 0.3
Portugal 2.4 0.0 -2.5 1.3 -2.2 -1.8
Spain 3.6 0.9 -3.7 -0.1 0.8 1.1
Real GDP growth
Policy options
• Successful deleveraging questionable unless growth is restored 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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