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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. – • Interaction between needed improvements in competitiveness and high levels of private indebtedness. – • Large-scale fiscal consolidation → reduce income → financial distress and banking problems → further depress economic growth (Eggertsson and Krugman, 2010). 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) 0 250 200 ‐20 150 100 ‐40 %GDP 50 ‐60 0 ‐50 ‐100 ‐80 ‐150 ‐200 ‐100 ‐250 ‐300 ‐120 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 Significant competitiveness adjustments required Fiscal deficits have offset increases in corporate net lending Table 1: Changes in non-financial corporations and government net lending (% of GDP) EA 17 Ireland Greece Spain Italy Portugal Corporate sector 2.7 3 4 8.9 1.9 5.4 Government sector -3.9 -11.9* -3.7 -11.2 -3 -5.6 Start year 2008 2007 2007 2007 2007 2008 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 Average change in entire sample Effect of balance sheet adjustment Number of episodes t=0 t=4 Actual change (2) (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 6.6 9.9 -3.3 24 Real growth d ni te U en Ki ng do m nd * itz er la Sw ed Sw in * Sp a l ga ay * w Po rtu N or * Ita ly nd s et he rla N d* an y la n er m Ire G ce Fr an an d ar ea Fi nl Eu ro um m ar k D en Be lg i Au st ria Large increases in household indebtedness Household debt as % of disposable income 300 1999 2009 250 200 150 100 50 0 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 Gross government and household debt % of GDP 140 Ireland 120 Portugal Households' gross debt 100 Spain 80 Euro area France Greece Germany 60 Belgium Italy 40 20 0 0 20 40 60 80 Government gross debt 100 120 140 160 Interaction between government and household debt Net government and household debt % of GDP 0 0 20 40 60 80 100 120 -50 Ireland Households' net debt Spain -100 Germany Euro area France Portugal -150 Italy -200 Belgium -250 Government net debt Household deleveraging during the current crisis Table 3: Household debt, 2007-2009 (% of disposable income) Austria Belgium Denmark Euro area Finland France Germany Ireland Italy Netherlands Norway Portugal Spain Sweden Switzerland U.K. 2007 86 77 255 94 97 73 93 194 57 222 177 128 130 131 170 152 2008 87 79 262 95 98 76 89 198 57 230 177 129 127 133 168 153 2009 87 83 275 97 101 77 89 199 61 241 n.a. 131 125 140 n.a. 149 Previous episodes of household deleveraging Household debt as a % of disposable income 120.0 Finland Sweden UK 100.0 80.0 60.0 40.0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Growth was key to previous episodes of deleveraging Real GDP growth 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 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.