April 2016, Volume 17, Issue 1
Q&A: Giancarlo Corsetti on Debt dynamics
Giancarlo Corsetti is Chair in Macroeconomics and Fellow of Clare College at the University of Cambridge. He is interested in open macroeconomics, in particular crises and policies in an international context. Corsetti’s RePEc/IDEAS profile.
EconomicDynamics: To some, it looks like Europe locked itself into a path with unsustainable debt that may even be entirely self-inflicted. What went wrong in the Euro area (EA)?
Giancarlo Corsetti: Consider a comparison between the US and the EA. The aggregate level of public debt in the US is not that different from the EA. Yet, the US has been able to reduce unemployment after the shock of the global crisis, running deficits and expanding the balance sheet of the Fed, without suffering any tension in the debt market. Initially, the crisis hit regions/states asymmetrically, causing large variations in unemployment and thus local fiscal conditions. Yet, thanks to a sufficiently developed institutional framework, there was no geographical polarization of risk and borrowing costs. In response to stabilization policies, aggregate recovery and regional convergence in unemployment rates went hand-in-hand. While the aggregate level of public debt in the US is not that different from the EA, the US has been able to stabilize economic activity (running deficits and expanding the balance sheet of the Fed) without suffering any significant tension in the debt market.
Conversely, even if the crisis shock in the EA was initially less geographically concentrated than in the US, an uncoordinated and unconvincing policy response in an institutional vacuum ended up magnifying regional weaknesses in fundamentals, up to generating a sovereign risk and ultimately a country-risk crisis.
As of today, aggregate economic activity has not recovered in the EA. The aggregate problem and the internal polarization are two sides of the same coin. In an economy with diverging fiscal, financial and macroeconomic conditions at regional level, (a) the transmission of monetary policy is profoundly asymmetric: borrowing conditions for public and private agents are quite different across borders and respond differently to policy decisions. (b) Fiscal policy has a strong contractionary (procyclical) bias. Most importantly, (c) a profound divergence in views and interests among national policy makers on how to adjust to shocks have reduced reciprocal trust to a historical minimum. Conflicts create continuing policy uncertainty and delay interventions. If anything is done, it is done too little too late.
In each country in the EA, the crisis has unique national features, i.e., rooted in a specific combination of financial, fiscal, and macroeconomic fragility. But after the emergence of the Greek problem, for the reasons highlighted above, the crisis became largely systemic with sovereign spread at times completely driven by common factors. It is well understood that multiple equilibria are possible in economies that lack policy credibility and have high levels of debt (a point stressed by many recent papers, see e.g. Lorenzoni and Werning 2015 or my work with Luca Dedola among others). The difficulty in policy formulation is that in practice, weak fundamentals and self-fulfilling expectations are near impossible to separate in a crisis. What happened in the EA after 2010 is best described by a combination of the two, reflecting rising fiscal liabilities and the inability to implement credible policy responses (or credible reform), at both domestic and union-wide level.
ED: Is there a general lesson for the literature on sovereign debt crisis?
GC: We typically think of the cost of default as hitting an economy ex post, when a credit event actually occurs (in the case of the EA, this can take the form of breakup of the union with forced conversion of debt into local currency). The recent EA experience reminds us that the mere possibility of default (or a currency breakup) in some state of the world at some point in the future can already cause large costs in the present, in terms of a persistent and deep macroeconomic distress. The problem tends to be mostly attributed to a ‘diabolic loop’ linking sovereigns and banks in a crisis (see e.g. Brunnermeier et al. 2016): as the price of public debt falls in a fiscal crisis, banks’ balance sheets suffer, the supply of credit contracts, financial stability is shaken, the fiscal outlook further deteriorates, creating the loop. In joint work with Keith Kuester, André Meier, Gernot Mueller, however, we early on realized that the problem is more pervasive. Even for large non-financial corporations, possibly multinationals that do not depend specifically on any national banking system, financial conditions are strongly correlated with those of the state in which they are headquartered. As a general pattern, private borrowing costs in the EA rose and borrowing conditions deteriorated sharply with sovereign risk premia.
With rising premia, the costs of prospective default may stem from either falling aggregate demand or tightening financial constraints, or a combination of the two. More empirical and theoretical work on this topic is badly needed, for instance, concerning the roots of the country-risk premia (uncertainty about tax regimes, macroeconomic conditions, debt overhang, and general political risks).
ED: You have tried to answer some of these issues.
GC: I have mainly focused on the transmission via aggregate demand, based on version of the New-Keynesian model set up by Curdia-Woodford (2010). In Corsetti et al. (2013 and 2014), we show that, with policy rates at the zero lower bound, not only may adverse cyclical shocks be substantially amplified by the implied deterioration of the fiscal outlook, but also, under the same conditions, fiscal policy becomes an unreliable tool. The large multiplier of government spending at the zero lower bound that has been widely discussed in recent literature may not materialize. In the model, first, the size—in fact, even the sign—of the multiplier appears to be quite sensitive to the extent of nominal distortions and market expectations concerning the persistence of the cyclical shocks. Second, sovereign risk affects indeterminacy, raising the risk that expectations become unanchored.
To wit: suppose that, in a monetary union with policy rates at the zero lower bound, markets develop arbitrary pessimistic view of the macroeconomic development in a country, implying a string of higher deficits and debt in the near future. All else equal, this translates into a deterioration of the country’s fiscal outlook, which in turn raises country risk and the borrowing costs for the private sector. Aggregate demand falls. With some downward nominal rigidities, the ensuing fall in economic activities validates ex post the initial, arbitrary, expectations. A similar mechanism may depress output via lower investment and growth (a channel active also in the absence of nominal rigidities). Note that, from the vantage point of market participants, the crisis and downturn appears to be entirely justified by weak fundamentals.
Rethinking the evidence of the EA crisis in light of this model, it is quite clear that stemming the above vicious circle required more than just procyclical deficits (the first reaction to the crisis)—especially when crash budget corrections contribute very little to restore policy credibility, at both domestic and union-wide levels.
To illustrate the potential costs of above mechanisms, contrast the quarterly GDP growth in the UK and EA crisis countries after the crisis. Take Italy. Before the summer of 2011, when the sovereign risk crisis extended to Italy, the GDP in the two countries (setting 2008Q1=100) moved in synch. After 2011, when the sovereign risk crisis hit Italy in full force, the UK has remained on a path of low but steady growth. Italy lost more than 10 percentage points to the UK. Between 2011 and 2015, the Italian debt rose from below 120 to above 132 percent of GDP. Based on the premise that the crisis was in part self-fulfilling, and reflected the inability of the EA policymakers to resolve their differences and conflicts, much of the economic and social costs of this crisis could have been avoided. And of course it could have been much worse without the Outright Monetary Transactions (OMT).
ED: Can policy do anything about it?
GC: In a belief-driven crisis, the first line of defence can be provided by central banks. Surprisingly, until very recently very little work has been devoted to the subject. In recent joint work with Luca Dedola, we have analyzed the conditions under which the central bank can rule out self-fulfilling sovereign default (mind: not fundamental default) via a credible threat to intervene in the government debt market (Corsetti and Dedola 2016). The starting point of our analysis is that central banks can issue liabilities in the form of (possibly interest bearing) monetary assets that are only exposed to the risk of inflation, not to the risk of default. Hence, when a central bank purchases debt, it effectively swaps default-risky with default free nominal liabilities, lowering the cost of borrowing. It is by virtue of this mechanism that, when markets coordinate their expectations on anticipation of (non-fundamental) default, central bank interventions on an appropriate scale can prevent the cost of issuing debt from raising substantially, and thus prevent default from becoming an attractive policy option for fiscal policymakers. Theory here is important to clarify that a “monetary backstop” to government debt needs not rely on a (threat of) debt debasement via inflation. Quite the opposite: the credibility of a monetary backstop via interventions in the debt market may be at stake if these foreshadow high future inflation. It turns out that a strong aversion to inflation, shared by policymakers and society, is a key precondition for its success.
Arguably, most central banks in advanced countries, if only implicitly, have provided a monetary backstop to government throughout the crisis years. Before 2012, the European Monetary Union lacked the required institutional framework for the ECB to do so. This framework could only come into existence after member states finally agreed on a reform of the fiscal rules, on the creation of the European Stability Mechanism (addressing conditionality), as well as on a blueprint for banking union. In September 2012, the ECB was eventually in a position to launch its OMT programme (still, amid political objections).
The importance of these developments in 2012 for the integrity of euro area cannot be overemphasized. Yet they came late and only addressed part of the ongoing problems. Financial and macroeconomic conditions in problematic countries continue to be weak. There has been little or no reversal of internal fragmentation and polarization.
As Europeans are rethinking and debating the institutional future of the euro, there are several questions that require more economic analysis. Ultimately, the responsibility of designing strong fiscal institutions in the EA cannot but remain with national governments. At the same time, it is important to recognize that, logically, debt sustainability also depends on the institutions and regimes of official lending. Europe has moved from IMF-style interventions to an approach lengthening the maturity of the loans and charging concessional rates. We need a theoretical framework to assess the effects and implications of these different approaches—a task that I am currently pursuing in joint work with Aitor Erce and Tim Uy.
Brunnermeier M., L. Garicano, P. R. Lane, M. Pagano, R. Reis, T. Santos, D. Thesmar, S. Van Nieuwerburgh, and D. Vayanos, (2016). “The Sovereign-Bank Diabolic Loop and ESBies,”American Economic Review P&P, May, forthcoming.
Corsetti G. and L. Dedola (2016). “The Mystery of the Printing Press: Self-fulfilling Debt crises, and Monetary Sovereignty,” CEPR Dicussion paper 11089.
Corsetti G., A. Erce, and T. Uy (2016). “Debt Sustainability and the Terms of Official Lending,” University of Cambridge , in Progress.
Corsetti G., K. Kuester, A. Meier, and G. Mueller (2013). “Sovereign Risk, Fiscal Policy, and Macroeconomic Stability,” Economic Journal, February, pages F99-F132.
Corsetti G., K. Kuester, A. Meier, and G. Mueller (2014). “Sovereign risk and belief-driven fluctuations in the euro area,” Journal of Monetary Economics, vol. 61, pages 53-73.
Curdia V. and M. Woodford (2010). “Credit spreads and monetary policy,” Journal of Money, Credit and Banking, vol. 42(s1), pages 3-35.
Lorenzoni G. and I. Werning (2015). “Slow Moving Debt Crises,” mimeo, MIT.