Coen Teulings presented a model analyzing the macroeconomic effects of housing market shocks. The model considers an overlapping generations economy with several industries. A negative productivity shock and rise in debt are examined. The shock leads to initial job losses in construction and domestic industries. Higher taxes are used to stabilize debt, slowing the recovery. Consumption falls as current generations' wealth and human capital decline from lower house prices and unemployment. However, consumption is postponed rather than permanently reduced as new generations are unaffected. The optimal fiscal policy balances the wealth distribution between current and future generations.

1. NEW APPROACHES
TO ECONOMIC CHALLENGES
EMPLOYMENT AND
MACRO POLICY
IN THE AFTERMATH
OF THE CRISIS
Coen Teulings
University of Cambridge
Presentation OECD, Paris
14 February 2014

2. Introduction



Employment at this stage of European history
Based on my previous CPB experience
Minimum wages? EPL? Wage subsidies?
?

3. Introduction



Employment at this stage of European history
Based on my previous CPB experience
Minimum wages? EPL? Wage subsidies?

4. Introduction





Employment at this stage of European history
Based on my previous CPB experience
Minimum wages? EPL? Wage subsidies?
Housing and macro policy
On-going research

5. Overview of the talk
1.
2.
3.
4.
5.
Stylized facts
Theory framework
Outline of the model
Policy experiment
The 10 commandments

6. Overview of the talk
1.
2.
3.
4.
5.
Stylized facts
Theory framework
Outline of the model
Policy experiment
The 10 commandments

7. The effect of Financial Crises
15 cases (Reinhart & Rogoff)
Peak to Trough
(%)
Income per head
Duration (years)
-9
1.9
7
4.8
House prices
-36
6.0
Stock prices
-56
3.4
86
3.0
Unemployment
Sovereign debt

8. GDP effect largely permanent
Sweden
Hong Kong,
Finland
Indonesia

9. House price slumps
Benetrix, Eichengreen, O’Rourke

10. Anecdotical Evidence on Europe

House price decline ↔ Unemployment
 Small
decline: Ger, Swe, Nl (till 2010)
 Strong decline: Esp, Ire, UK, Denmark, Nl (since
2010)
 Denmark and Nl high mortgage debt, unemployment

Spain
 25%
males work in construction
 fall in human capital

Current account since 2002
 Surpluses:
Ger, Swe, Denmark, Nl, Austria, Finland
 Deficits: UK, Gre, Esp, Por

11. House prices

12. Unemployment

13. Sovereign debt interest rate

14. House price overvalued?

15. House prices, wealth,
employment
Mian & Sufi

16. Decomposition of demand

17. Fiscal multiplier

18. Overview of the talk
1.
2.
3.
4.
5.
Stylized facts
Theory framework
Outline of the model
Policy experiment
The 10 commandments

19. House price decline =
Wealth transfer between generations

High house prices
 Good
for current generation: wealthier
 Bad for future generation: must buy expensive houses

Hence: fall in house prices = wealth transfer
 Large!

30% decline = 60% of GDP
= 80% of sovereign debt
Balance budget reduction in tax deductibility =
intergenerational wealth transfer
 Value
of housing captures NPV deductibility

20. Saving response




Take a real, not a financial view of saving
What is saving in a small open economy?
Export more!
Shift of employment from domestic to tradable

21. Keynes or Friedman?




Paradoxical situation
Only current income matters?
House price decline would be irrelevant
Argument relies on Permanent Income
Hypothesis
Can we do macro without rigid prices?
 Would
be much simpler!
 It turns out we cannot

22. Overview of the talk
1.
2.
3.
4.
5.
Stylized facts
Theory framework
Outline of the model
Policy experiment
The 10 commandments

23. Structure of Economy

Overlapping generations model Blanchard-Yaari



Workers die at fixed rate 2. 5%, new cohorts enter
Once and for all shock, perfect foresight after
5 industries + share in consumption
Tradable
 Domestic
 Informal
 Construction/Land
 Government


20%
25%
25%
5%
25%
Cobb Douglas utility
Both inter-temporal and across commodities
 Hence: constant gross consumption shares over lifetime


24. Unemployment



Workers enter unemployed
Industry specific human capital
Switching industries requires unemployment
 2-5

years period
No congestion effects
 Runs
counter to empirical evidence

25. Labour reallocation

If wages are flexible
 Hiring
industries pay full wage
 Non-hiring industries pay lower, clearing wage
downsizing by retirement
 Firing industries pay lower bound wage
firing
= quitting
unemployment
= good
limit to wage reductions, though at low levels:
50% fall

If wages are inflexible
 Wage
determined by competitiveness on global
market
 Drop in industry demand? Firing workers

26. Government




Pays interest on debt 1.5%
Pays its civil servants
(Pays mortgage subsidy)
Collects consumption tax
 VAT
…
but also income tax: pension contributions are tax
exempt

Policy instrument: future taxes
 We

assume an exponential path back to LR equilibrium
Hence:
 Model
= system of linear differential equations
 … if there is no construction (housing is only land)

27. What not?


Apart from housing, no capital
Constant interest rate
 Hence:





no sovereign debt crisis
No financial intermediation
No uncertainty / precautionary saving
No bequest motive
More general: no behavioural issues
Perfectly elastic demand for tradable

28. Overview of the talk
1.
2.
3.
4.
5.
Stylized facts
Theory framework
Outline of the model
Policy experiment
The 10 commandments

29. Policy experiment

Start from a steady equilibrium
 Applies
to the Netherlands (?)
 … but not to Spain (excess construction, bubble)
 … and Denmark (overheating?)
 … Germany (catching up due to labour market reform)

Shock to productivity ↓and debt↑ (e.g. 10%)
 Hence:


excess housing (e.g. 5%)
Policy response, fully credible
Perfect foresight of adjustment path

30. What policy response?


No response = No option: higher interest
Raise taxes to cover only higher interest?
 Optimal
from tax smoothing perspective
 Sovereign debt becomes random walk
 Increases vulnerability for future shocks

Hence: recovery of old public debt level
 60%?
 Temporarily

higher taxes, converging to steady state
Question however: at what speed?
 Risk
of (too much) overshooting

31. Phases in adjustment process
Typical adjustment process
1.
Initial non-hiring/firing in domestic
(construction?)


2.
3.
4.
Firing only under wage inflexibility
Accelerator mechanism
Substitution to informal industry due to high
tax
Domestic starts rehiring
Construction starts rehiring

32. Effect on wealth and consumption

Human capital current generation falls
1.
2.
Lower wages in non-hiring industries
Unemployment
Financial capital falls due to house prices
Hence: permanently lower consumption




Retirement + interest rate = 4%
Fits wealth effect of 4 cents per euro
New generations gross consumption unaffected



Conditional on tax policy
Consumption effect lasts long

Unemployment effect not

33. Implications for debt and deficit




Higher taxes reduce wealth current generation
… and induce inter-temporal substitution
Hence: aggregate consumption postponed
Leads to employment shift to tradable
…
which reduces value of human capital
 … and hence current consumption
 ... and house prices, hence consumption

Short run effect on deficit is negative
 Might
even be negative? Open research question
 Fits multiplier studies Auerbach & Gorodnichenko

34. Welfare evaluation




Optimal fiscal policy = setting wealth distribution
between generations
Market is efficient
Hence, postponing hurts future generations?
Might be false: taxation leads to distortions
 Temporary
overshooting
 Inefficient unemployment instead of retirement
 Substitution to informal sector

All depends crucially on degree of wage flexibility
 Assuming
wage flexibility contradicts empirical evidence

35. Other things


Tax treatment mortgage interest:
balance budget reform makes things worse!
Same applies to NPV of market distortions
 Italy
…

and in the future Germany?
Bubbles?
 Lead
to excess consumption
 Adjustment unavoidable
 Critical role trade balance
 Also bubble adjustment can be overshooting

36. Overview of the talk
1.
2.
3.
4.
5.
Stylized facts
Theory framework
Outline of the model
Policy experiment
The 10 commandments

37. The 10 Commandments (I)
1.
2.
3.
4.
5.
House price decline
=
intergenerational wealth transfer (large!)
House price variability, not level is main
concern
Reduction sovereign debt
=
substitute, not complement
Adequate response fiscal policy:
intergenerational insurance
Requires long run stance fiscal policy

38. The 10 Commandments (II)
1.
House price decline = intergenerational wealth transfer
2.
House price variability, not level is main concern
3.
Reduction sovereign debt = substitute, not complement
4.
Adequate response fiscal policy: intergenerational insurance
5.
Requires long run stance fiscal policy
6.
7.
8.
9.
10.
Shock therapy likely to be counterproductive
Maybe adverse short run response budget
deficit
Hence: budget deficit=wrong control variable
Hence: EU regulatory framework inadequate
role output gap
Applies also to product market reforms