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Presentation from ADEMU Fiscal Risk and Public Sector Balance Sheets Conference at the University of Bonn, July 6-7

- 1. When Fiscal Consolidation Meets Private Deleveraging1 Javier Andrés2, Óscar Arce3 and Carlos Thomas3 ADEMU Workshop "Fiscal Risk and Public Sector Balance Sheets", 6-7 July 2017 1The views expressed herein are those of the authors and not necessarily those of Banco de España or the Eurosystem 2Universidad de Valencia, Banco de España 3Banco de España 1 / 32
- 2. Outline 1 Introduction 2 Model 3 Baseline deleveraging scenario 4 Fiscal consolidation Consolidation size Gradualism 5 Concluding remarks 6 Appendix 2 / 32
- 3. Introduction Many countries face lengthy private and public debt consolidation processes I amid low growth and in‡ation, and binding ZLB. Key question: e¤ects of …scal consolidation in an environment of high private debt cum deleveraging This paper: develop a framework to analyze the interaction between public and private deleveraging 3 / 32
- 4. Framework and main questions Model of small open economy in a monetary union with private and public debt Households and …rms borrow long term subject to collateral constraints Large negative …nancial shock triggers a slow private deleveraging process I Exit from deleveraging is endogenous Analyze how the size and speed (and composition) of …scal consolidation a¤ects the economy I including (and especially) through its impact on private deleveraging 4 / 32
- 5. Main result Larger and front-loaded consolidations entail larger (relative) output/welfare losses I largely by postponing the end of private deleveraging Argument in favor of deleveraging-friendly consolidations 5 / 32
- 6. Related literature (I) Before the crisis: extensive literature on the e¤ects of consolidations. I Front-loaded adjustments more e¤ective and less costly I Adjustments in public spending, rather than tax hikes, more e¤ective, lasting and less costly. The crisis has called these results called into question. I Christiano et al. (2011), Woodford, 2011 and Eggertsson (2010): at the ZLB, spending cuts depress output more than tax hikes I Erceg and Lindé (2014): …scal multipliers depend on the incidence of …scal shocks on the duration of ZLB. Little work on the interaction between private debt and …scal consolidations: I Batini, Melina and Villa (2016) is one exception (see also: IMF Fiscal Monitor Oct 2016) 6 / 32
- 7. Related literature (II) The role of economic policies in a high debt & deleveraging environment cum ZLB: I Andrés, Arce and Thomas (2017): "Structural reforms in a debt overhang". F SOE with exogenous monetary policy I Arce, Hurtado and Thomas (2015): "Policy Spillovers and Synergies in a Monetary Union" F 2-country model with endogenous ZLB 7 / 32
- 8. Outline 1 Introduction 2 Model 3 Baseline deleveraging scenario 4 Fiscal consolidation Consolidation size Gradualism 5 Concluding remarks 6 Appendix 8 / 32
- 9. Model structure Small open economy in a monetary union ) monetary policy exogenous ZLB. Four main agents I Patient households (lenders) I Impatient households (borrowers) I (Impatient) entrepreneurs (borrowers) I Government: consumes, sets taxes and issues debt. Three production sectors I Consumption goods (entrepreneurs + retailers) I Equipment capital producers I Construction Trade with rest of MU: consumption goods and foreign debt. Standard real and nominal frictions: investment adjustment costs, nominal price and wage rigidities 9 / 32
- 10. Impatient households Maximize E0 ∞ ∑ t=0 βt ( log ct + ϑ log ht χ Z 1 0 nC t (i)1+ϕ 1 + ϕ di ) subject to (1 + τc t ) ct + ph t [ht (1 δh) ht 1] = bt Rt 1 πt bt 1 Tt + (1 τw t ) Z 1 0 Wt (i) Pt nC t (i) di and an asymmetric debt constraint ... 10 / 32
- 11. Long-run private debt and borrowing constraints We assume long-run debt 11 / 32
- 12. Long-run private debt and borrowing constraints We assume long-run debt I A constant fraction 1 γ of outstanding nominal principal is amortized each period ( Woodford, 2001). 11 / 32
- 13. Long-run private debt and borrowing constraints We assume long-run debt I A constant fraction 1 γ of outstanding nominal principal is amortized each period ( Woodford, 2001). Dynamics of real outstanding debt: bt = bt 1 πt |{z} initial debt 1 γ πt bt 1 | {z } amortization + bnew t |{z} gross new credit net of voluntary prepayments = γ πt bt 1 + bnew t . 11 / 32
- 14. Long-run private debt and borrowing constraints We assume long-run debt I A constant fraction 1 γ of outstanding nominal principal is amortized each period ( Woodford, 2001). Dynamics of real outstanding debt: bt = bt 1 πt |{z} initial debt 1 γ πt bt 1 | {z } amortization + bnew t |{z} gross new credit net of voluntary prepayments = γ πt bt 1 + bnew t . In ’normal times’, borrowing is subject to a collateral constraint (Kiyotaki & Moore 97; Iacoviello 05) 11 / 32
- 15. Long-run private debt and borrowing constraints We assume long-run debt I A constant fraction 1 γ of outstanding nominal principal is amortized each period ( Woodford, 2001). Dynamics of real outstanding debt: bt = bt 1 πt |{z} initial debt 1 γ πt bt 1 | {z } amortization + bnew t |{z} gross new credit net of voluntary prepayments = γ πt bt 1 + bnew t . In ’normal times’, borrowing is subject to a collateral constraint (Kiyotaki & Moore 97; Iacoviello 05) I but debtors cannot be forced to repay faster than at contractual rate 11 / 32
- 16. Long-run private debt and borrowing constraints We assume long-run debt I A constant fraction 1 γ of outstanding nominal principal is amortized each period ( Woodford, 2001). Dynamics of real outstanding debt: bt = bt 1 πt |{z} initial debt 1 γ πt bt 1 | {z } amortization + bnew t |{z} gross new credit net of voluntary prepayments = γ πt bt 1 + bnew t . In ’normal times’, borrowing is subject to a collateral constraint (Kiyotaki & Moore 97; Iacoviello 05) I but debtors cannot be forced to repay faster than at contractual rate Borrowing constraint, bnew t maxf0, collateral value z }| { mt 1 Rt Etπt+1ph t+1ht contractual amort. path z }| { γ πt bt 1 | {z } ’excess’collateral g 11 / 32
- 17. Long-run private debt and borrowing constraints In equilibrium, no voluntary early payments: bnew t 0 ) An asymmetric debt regime: 12 / 32
- 18. Long-run private debt and borrowing constraints In equilibrium, no voluntary early payments: bnew t 0 ) An asymmetric debt regime: I ’Normal’regime (excess collateral > 0) =) bnew t > 0 and bt equals collateral value, bt = mt 1 Rt Etπt+1ph t+1ht 12 / 32
- 19. Long-run private debt and borrowing constraints In equilibrium, no voluntary early payments: bnew t 0 ) An asymmetric debt regime: I ’Normal’regime (excess collateral > 0) =) bnew t > 0 and bt equals collateral value, bt = mt 1 Rt Etπt+1ph t+1ht I ’Deleveraging’regime (excess collateral < 0) =) bnew t = 0 and bt follows the contractual amortization path, bt = γ πt bt 1 ) Net debt ‡ows: bt Rt 1 πt bt 1 = (Rt 1 1)+(1 γ) πt bt 1 (interest + amortization payments) 12 / 32
- 20. Fiscal policy Budget constraint (CPI-de‡ated), b g t = Rt 1 πt b g t 1 + PH,t Pt gt τw t wtnt τc tcTOT t τk t ∑ s=e,r,h,k Πs t Tt. 13 / 32
- 21. Fiscal policy Budget constraint (CPI-de‡ated), b g t = Rt 1 πt b g t 1 + PH,t Pt gt τw t wtnt τc tcTOT t τk t ∑ s=e,r,h,k Πs t Tt. Fiscal rule, ﬁt = ﬁt 1 + φb b gy t 1 ¯bgy + φ∆b b gy t b gy t 1 , ﬁt 2 fgt, τw t , τc t, τk t , Ttg, where b gy t Ptb g t PH,tgdpt : gov’t debt/GDP. 13 / 32
- 22. Fiscal policy Budget constraint (CPI-de‡ated), b g t = Rt 1 πt b g t 1 + PH,t Pt gt τw t wtnt τc tcTOT t τk t ∑ s=e,r,h,k Πs t Tt. Fiscal rule, ﬁt = ﬁt 1 + φb b gy t 1 ¯bgy + φ∆b b gy t b gy t 1 , ﬁt 2 fgt, τw t , τc t, τk t , Ttg, where b gy t Ptb g t PH,tgdpt : gov’t debt/GDP. Fiscal consolidations consist of reductions in ¯bgy 13 / 32
- 23. Fiscal policy Budget constraint (CPI-de‡ated), b g t = Rt 1 πt b g t 1 + PH,t Pt gt τw t wtnt τc tcTOT t τk t ∑ s=e,r,h,k Πs t Tt. Fiscal rule, ﬁt = ﬁt 1 + φb b gy t 1 ¯bgy + φ∆b b gy t b gy t 1 , ﬁt 2 fgt, τw t , τc t, τk t , Ttg, where b gy t Ptb g t PH,tgdpt : gov’t debt/GDP. Fiscal consolidations consist of reductions in ¯bgy I Size: ∆¯bgy 13 / 32
- 24. Fiscal policy Budget constraint (CPI-de‡ated), b g t = Rt 1 πt b g t 1 + PH,t Pt gt τw t wtnt τc tcTOT t τk t ∑ s=e,r,h,k Πs t Tt. Fiscal rule, ﬁt = ﬁt 1 + φb b gy t 1 ¯bgy + φ∆b b gy t b gy t 1 , ﬁt 2 fgt, τw t , τc t, τk t , Ttg, where b gy t Ptb g t PH,tgdpt : gov’t debt/GDP. Fiscal consolidations consist of reductions in ¯bgy I Size: ∆¯bgy I Gradualism: φb 13 / 32
- 25. Fiscal policy Budget constraint (CPI-de‡ated), b g t = Rt 1 πt b g t 1 + PH,t Pt gt τw t wtnt τc tcTOT t τk t ∑ s=e,r,h,k Πs t Tt. Fiscal rule, ﬁt = ﬁt 1 + φb b gy t 1 ¯bgy + φ∆b b gy t b gy t 1 , ﬁt 2 fgt, τw t , τc t, τk t , Ttg, where b gy t Ptb g t PH,tgdpt : gov’t debt/GDP. Fiscal consolidations consist of reductions in ¯bgy I Size: ∆¯bgy I Gradualism: φb I (Composition: choice of instrument ﬁt) 13 / 32
- 26. Calibration Calibrated to Spain pre-crisis (2007) I Key ratios: HH & NFC debt/GDP, NFA position/GDP, etc. Debt constraints: I LTV ratios: ¯m = 0.85, ¯me = 0.69 I Amortization rates: 1 γ = 0.02, 1 γe = 0.03 ) average age of outstanding debt: γ/ (1 γ) = 12, γe/ (1 γe) = 8 years Fiscal policy: I Initial tax rates ¯τx, x = c, w, k, set as in Stähler & Thomas (2011, FiMod model) I Initial gov’t debt ratio: ¯bgy = 80% I Fiscal rule coe¢ cients (φb, φ∆b) set to make the de…cit paths roughly similar across instruments 14 / 32
- 27. Outline 1 Introduction 2 Model 3 Baseline deleveraging scenario 4 Fiscal consolidation Consolidation size Gradualism 5 Concluding remarks 6 Appendix 15 / 32
- 28. Baseline scenario: a deleveraging shock Gradual, permanent fall in LTV ratios: mt, me t mt = (1 ρm) ¯m + ρmmt 1 similarly for me t Set ρm = 0.75; shock size, j∆ ¯mj = 5 pp ' Spanish experience Economy enters on impact the slow deleveraging regime 16 / 32
- 29. Baseline deleveraging scenario: debt dynamics 0 5 10 15 20 25 30 35 40 80 85 90 95 100 105 110 115 120 125 130 Entrepreneur debt quarters %ofSSGDP 0 5 10 15 20 25 30 35 40 40 45 50 55 60 65 70 75 80 85 90 quarters %ofSSGDP Household debt contractual amortization path collateral values debt end of deleveraging (T*,T**) 17 / 32
- 30. Baseline deleveraging scenario: macroeconomic adjustment 0 10 20 30 40 -6 -4 -2 0 GDP % 0 10 20 30 40 -4 -2 0 2 employment % 0 10 20 30 40 50 60 70 80 90 household debt/annual GDP pp 0 10 20 30 40 100 110 120 130 entrepreneurial debt/annual GDP pp 0 10 20 30 40 -4 -3 -2 -1 0 real estate prices % 0 10 20 30 40 -15 -10 -5 0 total investment % 0 10 20 30 40 -4 -2 0 2 total consumption % 0 10 20 30 40 -2 -1 0 1 CPI inflation annualizedpp 0 10 20 30 40 -3 -2 -1 0 real wage quarters % 0 10 20 30 40 -1 -0.5 0 0.5 1 ex-ante real interest rate quarters annualizedpp 0 10 20 30 40 -2 0 2 4 terms of trade quarters % 0 10 20 30 40 -0.5 0 0.5 1 1.5 net exports quarters %ofSSGDP 18 / 32
- 31. Outline 1 Introduction 2 Model 3 Baseline deleveraging scenario 4 Fiscal consolidation Consolidation size Gradualism 5 Concluding remarks 6 Appendix 19 / 32
- 32. Fiscal consolidation under private deleveraging Against the background of this baseline scenario... ... consider a …scal consolidation of (baseline) size ∆¯bgy = 20 pp ¯bgy falls from 80% to 60% Fiscal instrument: gov’t spending (gt) 20 / 32
- 33. Fiscal consolidation: macroeconomic impact 0 10 20 30 40 -8 -6 -4 -2 0 GDP quarters % 0 10 20 30 40 50 60 70 80 90 government debt/GDP quarters pp 0 10 20 30 40 -5 -4 -3 -2 -1 0 1 private consumption quarters % 0 10 20 30 40 50 60 70 80 90 household debt/annual GDP quarters pp 0 10 20 30 40 100 110 120 130 140 entrepreneurial debt/annual GDP quarters pp 0 10 20 30 40 -5 -4 -3 -2 -1 0 1 2 CPI inflation quarters annualizedpp 21 / 32
- 34. Fiscal consolidation: the ’duration’channel 0 5 10 15 20 25 30 35 40 50 55 60 65 70 75 80 85 90 Household debt quarters %ofSSannualGDP collateral value, baseline debt, baseline collateral value, fiscal cons. debt, fiscal cons. bt = γ*bt-1 /πt for t<T** Tcons **T** 22 / 32
- 35. Consolidation size Compare consolidations of di¤erent sizes in terms of GDP e¤ects rescaled by size, ∆gdpt ∆¯bgy , ∆gdpt gdpcons t gdpbase t Similar to ’…scal sacri…ce ratio’(e.g. Erceg & Lindé, 2013) Show e¤ects relative to baseline (no consolidation) scenario: ∆gdpt 23 / 32
- 36. Small vs large …scal consolidation 0 5 10 15 20 25 30 35 40 45 50 -0.2 -0.15 -0.1 -0.05 0 0.05 GDP effect of fiscal consolidations quarters %/pp size = 1 pp size = 20 pp 24 / 32
- 37. Small vs large …scal consolidation Relative welfare and output losses Size: 1 pp 20 pp Rel. PV output losses * 0.070 0.081 Rel. welfare loss ** 0.024 0.027 [T , T ] [9, 17] [11, 19] * ∑40 t=1 βt 1 ∆gdpt/ ∑40 t=1 βt 1 ∆¯bgy ** In % of permanent consumption 25 / 32
- 38. Gradualism Consider di¤erent coe¢ cients φb on debt ratio deviations from target (b gy t 1 ¯bgy) in …scal rule Size …xed at baseline (20pp) 26 / 32
- 40. Gradualism Welfare losses (% of perm. cons.) Scenario welf. loss (T , T ) Front-loaded 0.67 (12 , 22) Baseline 0.55 (11 , 19) Gradual 0.42 (10 , 18) 28 / 32
- 41. Outline 1 Introduction 2 Model 3 Baseline deleveraging scenario 4 Fiscal consolidation Consolidation size Gradualism 5 Concluding remarks 6 Appendix 29 / 32
- 42. Concluding remarks Understand the interconnection between …scal consolidation and private deleveraging New channel of …scal consolidations: e¤ect on private deleveraging dynamics Key …nding: larger and front-loaded …scal consolidations are (relatively) more costly I by hampering the recovery of borrowers’net worth (collateral values, debt de‡ation) I and thus prolonging their deleveraging processes Results speak in favor of “deleveraging-friendly” consolidation strategies 30 / 32
- 43. Outline 1 Introduction 2 Model 3 Baseline deleveraging scenario 4 Fiscal consolidation Consolidation size Gradualism 5 Concluding remarks 6 Appendix 31 / 32
- 44. Alternative …scal instruments Di¤erent …scal instruments have a potentially very di¤erent macro impact, through the private-deleveraging channel 32 / 32