Early-warning indicators for debt sustainability Casper van Ewijk - PowerPoint PPT Presentation

Early-warning indicators for debt sustainability Casper van Ewijk Jasper Lukkezen Hugo Rojas-Romagosa

Our main message in the words of Rudi Dornbusch Think of someone who has made a great expertise of drunk driving, regularly drives drunk, tells you that he never has a problem, and one day there is a terrible, terrible accident. And he’ll say, "Well, it was the red light. It wasn’t my being drunk. Normally that light is green." CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 2 / 30 Early-warning indicators | 8 October 2013

How to assess debt sustainability? • A sustainable fiscal policy can be continued without losing control over the debt level • Towards stochastic analysis ◮ macro-volatility of interest and growth (economic uncertainty) ◮ response of fiscal policy to setbacks (policy maker) • Indicator captures upward risk of the debt level ◮ Expected debt increase which happens every 40 years ◮ In 2007, indicator identifies countries with sustainability issues ◮ Complements SGP (3%, 60%) and ageing (S1, S2) indicators CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 3 / 30 Early-warning indicators | 8 October 2013

Stochastic analysis Which government is more ’in control of its debt level’? Belgium Portugal 140% 140% 120% 120% 100% 100% 80% 80% 80% 60% 60% 40% 40% 20% 20% 0% 0% 2007 2012 2017 2022 2027 2007 2007 2012 2012 2017 2017 2022 2022 2027 2027 CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 4 / 30 Early-warning indicators | 8 October 2013

’at risk’ indicator captures upward risk CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 5 / 30 Early-warning indicators | 8 October 2013

Rest of the presentation 1. What drives the debt level? 2. Theoretical debt sustainability: Modified Aaron condition 3. Stochastic simulations 4. The added value of the indicator CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 6 / 30 Early-warning indicators | 8 October 2013

What drives the debt level? • Accounting equation for the debt level: debt t + 1 = 1 + interest t × debt t − primary surplus t . 1 + growth t • Contributing channels 1. Growth 2. Interest 3. Surplus (fiscal response) CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 7 / 30 Early-warning indicators | 8 October 2013

Autonomous debt reduction till 80s Interest minus growth rate The Netherlands 1.05 Gamma parameter 1 .95 .9 1948 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 year CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 8 / 30 Early-warning indicators | 8 October 2013

What drives the debt level? • Accounting equation for the debt level: debt t + 1 = 1 + interest t × debt t − primary surplus t . 1 + growth t • Contributing channels 1. Growth 2. Interest 3. Surplus (fiscal response) CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 9 / 30 Early-warning indicators | 8 October 2013

Debt / GDP 10 / 30 CPB Netherlands Bureau for Economic Policy Analysis .4 .6 .8 1 1.2 1.4 responded When Belgian debt increased, government budget 1955 1958 1961 1964 1967 1970 Debt ratio 1973 1976 1979 Belgium year 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 Primary Surplus / GDP −.1 −.05 0 .05 .1 Early-warning indicators | 8 October 2013 Lunchtalk at Bruegel 1955 1958 1961 1964 1967 Primary surplus 1970 1973 1976 1979 Belgium year 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

When Portuguese debt increased, government budget did not respond Debt ratio Primary surplus Portugal Portugal .05 Primary Surplus / GDP 1 Debt / GDP .8 0 .6 −.05 .4 .2 −.1 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 year year CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 11 / 30 Early-warning indicators | 8 October 2013

Theoretical debt sustainability: Modified Aaron condition interest − growth − fiscal response < 0 . Modified Aaron condition: with fiscal response the estimated responsiveness of surplus to debt. Then: If this condition is satisfied, debt converges to a steady state. CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 12 / 30 Early-warning indicators | 8 October 2013

Data, simulation method & results CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 13 / 30 Early-warning indicators | 8 October 2013

Data: long time series for fiscal response estimation • Main results: Post-WW2 data • Robustness: entire sample Country Sample Observations USA 1792-2011 220 GBR 1691-2011 321 NLD 1816-2011* 188 BEL 1830-2011* 160 DEU 1970-2011 42 ITA 1862-2011 150 ESP 1850-2011* 159 PRT 1852-2011 160 ISL 1908-2011 103 * = War data missing CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 14 / 30 Early-warning indicators | 8 October 2013

Modified Aaron condition satisfied for all countries CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 15 / 30 Early-warning indicators | 8 October 2013

Historically debt was sustainable • High growth and low real interest contributes to sustainability • Fiscal response significant and positive for USA, GBR, NLD, BEL, DEU and ITA not significant for ESP , PRT and ISL • Fiscal response robust when pre-WWII years are included ⇒ measures persistent institutional characteristic CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 16 / 30 Early-warning indicators | 8 October 2013

Since mid 80s: fiscal response required • growth > interest prior to 1987 and interest > growth afterwards ⇒ fiscal response required for sustainability • How bad is it? ⇒ Simulation needed CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 17 / 30 Early-warning indicators | 8 October 2013

Volatility much higher in Iceland USA ISL .2 .2 real growth real growth .1 .1 0 0 −.1 −.1 1950 1975 2000 1950 1975 2000 years years .1 .1 real interest real interest −.1 −.1 −.3 −.3 1950 1975 2000 1950 1975 2000 years years CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 18 / 30 Early-warning indicators | 8 October 2013

Stochastic simulation Simulate debt going forward: 1. Estimate the fiscal response 2. Simulate volatility in interest and growth rates (Budina and van Wijnbergen, 2008) using a VAR 3. Simulate debt at time t + 1 from time t debt, simulated volatility in interest and growth and estimated fiscal response CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 19 / 30 Early-warning indicators | 8 October 2013

Fiscal response reduces debt levels and volatility Germany, response=0 Germany, response=2.6% 140% 140% 120% 120% 100% 100% 80% 80% 60% 60% 40% 40% 20% 20% 0% 0% 2011 2016 2021 2011 2016 2021 CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 20 / 30 Early-warning indicators | 8 October 2013

Volatility in interest and growth increase debt volatility Germany, response=2.6% Spain, response=0 140% 140% 120% 120% 100% 100% 80% 80% 60% 60% 40% 40% 20% 20% 0% 0% 2011 2016 2021 2011 2016 2021 CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 21 / 30 Early-warning indicators | 8 October 2013

Simulation outcomes • Larger fiscal response reduces debt levels • Larger fiscal response and smaller interest and growth rate volatility reduce debt volatility • Define ’at risk’ indicator: debt level that is higher then 97.5% of the debt levels minus median debt level after 10 years. Remaining 2.5% ≈ > once every 40 years CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 22 / 30 Early-warning indicators | 8 October 2013

’at risk’ indicator CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 23 / 30 Early-warning indicators | 8 October 2013

2011 indicator CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 24 / 30 Early-warning indicators | 8 October 2013

Early-warning indicator • ’07 indicator value is highly correlated with ’09-’12 sovereign spreads. • ’07 sovereign spreads are not correlated with ’09-’12 sovereign spreads CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 25 / 30 Early-warning indicators | 8 October 2013

600 PRT 500 an '09-'12 CDS rate ISL 400 300 ITAESP 200 200 Mea BEL 100 GBR NLD DEU USA 0 0 5 10 15 20 25 30 35 'at risk'-indicator in '07

Discussion CPB Netherlands Bureau for Economic Policy Analysis Lunchtalk at Bruegel 27 / 30 Early-warning indicators | 8 October 2013