International Debt Deleveraging Luca Fornaro CREI and Universitat Pompeu Fabra 12 th Macroeconomic Policy Research Workshop Budapest, September 2013 1
Motivating facts: Household debt/GDP 120 Ireland Household debt/GDP (percent) 100 Un. Kingdom Portugal United States Spain 80 60 40 1999 2001 2003 2005 2007 2009 2011 2
Motivating facts: Current account/GDP 4 Euro core Current account/GDP (percent) 2 Japan 0 United Kingdom -2 United States -4 Euro periphery -6 1999 2001 2003 2005 2007 2009 2011 3
Motivating facts: GDP United States 102 Euro core 100 Real GDP (index, 2007=100) Japan 98 United Kingdom 96 94 92 Euro periphery 2007 2008 2009 2010 2011 2012 4
Research questions ◮ What happens when a group of financially integrated countries enters a process of debt deleveraging? ◮ What role does the exchange rate regime play? 5
This paper ◮ Provides a framework for understanding debt deleveraging in a group of financially integrated countries ◮ Key result: monetary unions are particularly prone to enter a liquidity trap during deleveraging 6
Overview of the framework ◮ World featuring a continuum of small open economies ◮ Foreign borrowing/lending is used to smooth the impact of idiosyncratic productivity shocks on consumption ◮ The deleveraging process is triggered by an unexpected permanent decrease in the (exogenous) borrowing limit 7
Overview of the results ◮ An unexpected drop in the borrowing limit generates a fall in the world interest rate ◮ With flexible exchange rates, production shifts toward high debt countries ◮ In a monetary union with nominal wage rigidities ◮ The fall in the interest rate is amplified ◮ Liquidity trap is associated with deep recession, especially in high-debt countries 8
Related literature ◮ Exchange rate regime and crises: Cespedes, Chang and Velasco (2004), Christiano, Gust and Roldos (2004), Gertler, Gilchrist and Natalucci (2007), Schmitt-Grohe and Uribe (2011) ◮ Deleveraging and liquidity traps: Eggertsson and Krugman (2010), Guerrieri and Lorenzoni (2010), Benigno and Romei (2012) 9
Outline A model of international deleveraging Deleveraging with flexible wages Deleveraging in a monetary union with nominal wage rigidities The zero lower bound Policy experiments 10
Outline A model of international deleveraging Deleveraging with flexible wages Deleveraging in a monetary union with nominal wage rigidities The zero lower bound Policy experiments 11
Model ◮ World composed of a continuum of small open economies ◮ Each economy is inhabited by a continuum of measure 1 of households and by a large number of firms 12
Household ◮ Expected lifetime utility in country i � ∞ � � β t U � C T i , t , C N � i , t , L i , t E 0 t =0 ◮ Budget constraint i , t + B i , t +1 C T i , t + p N i , t C N = w i , t L i , t + B i , t + Π i , t R t ◮ Borrowing constraint B i , t +1 ≥ − κ Optimality conditions 13
Firms ◮ Tradable sector � α T Y T i , t = A T � L T i , t i , t ◮ A T i , t is a country-specific productivity shock ◮ Non-tradable sector � α N Y N i , t = A N � L N i , t 14
Market clearing ◮ Tradable consumption good i , t − B i , t +1 C T i , t = Y T + B i , t R t ◮ Non-tradable consumption good C N i , t = Y N i , t ◮ Labor L i , t = L T i , t + L N i , t ◮ World market clearing � 1 � 1 � 1 C T Y T i , t d i = i , t d i ⇐ B i , t +1 d i = 0 ⇒ 0 0 0 15
Some useful definitions ◮ The stock of net foreign assets owned by country i at the end of period t is NFA i , t = B i , t +1 R t ◮ Current account � � 1 NFA i , t − NFA i , t − 1 = CA i , t = Y T i , t − C T i , t + B i , t 1 − R t − 1 16
Functional forms ◮ Preferences = C 1 − γ 1 − γ − L 1+ ψ C T , C N , L � � U 1 + ψ C T � ω � C N � 1 − ω � C = ◮ Productivity shock A T i , t = ρ A T i , t − 1 + ǫ i , t 17
Parameters Table 1: Parameters (annual) Value Source/Target Risk aversion γ = 4 Standard value Discount factor β = 0 . 9756 R = 1 . 025 Frisch elasticity of labor supply 1 /ψ = 1 Kimball and Shapiro (2008) Labor share in trad. sector α T = 0 . 65 Standard value Labor share in non-trad. sector α N = 0 . 65 Standard value Share of trad. in consumption ω = 0 . 5 Stockman and Tesar (1995) TFP process σ ǫ = 0 . 0194 Benigno and Thoenissen (2008) ρ = 0 . 84 Initial borrowing limit κ = 0 . 9 Debt/GDP= 20% 18
Policy functions Current account Labor 1.31 0.04 High TFP Low TFP 1.3 0.02 1.29 1.28 0 1.27 −0.02 1.26 1.25 −0.9 −0.8 −0.7 −0.6 −0.5 −0.9 −0.8 −0.7 −0.6 −0.5 Wealth at the start of the period: B t Wealth at the start of the period: B t 19
Distribution of net foreign assets/GDP 0.08 0.06 Fraction 0.04 0.02 0 −100 −50 0 50 100 150 200 250 300 Net foreign assets/GDP 20
Deleveraging shock ◮ Start from steady state with κ = κ H ◮ Unexpected permanent drop to κ = κ L < κ H ◮ I set κ L = 0 . 75 κ H (in the final steady state world debt/GDP is 15 percent) graph 21
Outline A model of international deleveraging Deleveraging with flexible wages Deleveraging in a monetary union with nominal wage rigidities The zero lower bound Policy experiments 22
Transitional dynamics Borrowing limit World debt/GDP 21 0.9 20 percent 0.8 19 0.7 0.6 18 −1 0 1 2 3 4 −1 0 1 2 3 4 World output Interest rate 3 % dev. from initial ss 0.2 Tradable good Non-tradable good 0.15 2 percent 0.1 1 0.05 0 0 −0.05 −1 0 1 2 3 4 −1 0 1 2 3 4 years years 23
Impact response across the NFA distribution Current account/GDP Output of tradables change from initial steady state 15 % deviation from initial ss B 0 < − k ′ 15 10 10 5 20th 50th p erc. p erc. 5 0 20th 50th 0 −5 p erc. p erc. −10 −5 −1 −0.5 0 0.5 1 −1 −0.5 0 0.5 1 Wealth at the start of the transition: B 0 Wealth at the start of the transition: B 0 Consumption of tradables Real wage 5 5 % deviation from initial ss % deviation from initial ss 0 0 20th 50th 20th 50th −5 −5 p erc. p erc. p erc. p erc. −10 −10 −1 −0.5 0 0.5 1 −1 −0.5 0 0.5 1 Wealth at the start of the transition: B 0 Wealth at the start of the transition: B 0 24 Current account equation
Wage rigidities and the nominal exchange rate ◮ Nominal wages adjust slowly to shocks ◮ Movements in the nominal exchange rate can act as a substitute for nominal wage flexibility Equations Proposition From the perspective of a single country the flexible wage equilibrium attains the constrained optimum. 25
Outline A model of international deleveraging Deleveraging with flexible wages Deleveraging in a monetary union with nominal wage rigidities The zero lower bound Policy experiments 26
A monetary union ◮ Budget constraint in terms of currency i , t + B i , t +1 P T t C T i , t + P N i , t C N = W i , t L i , t + B i , t + Π i , t R N t ◮ Bonds are denominated in units of currency ◮ Borrowing limit B i , t +1 ≥ − κ P T t +1 27
Central bank ◮ There is a single central bank that uses R N as its policy instrument ◮ Start by considering a central bank that targets zero inflation in the tradable sector P T t +1 = P T t 28
Nominal wage rigidities ◮ Nominal wages are fixed in the short run (period 0) ◮ From period t = 1 wages are fully flexible 29
Transitional dynamics in a monetary union Borrowing limit World debt/GDP 21 0.9 20 percent 0.8 19 0.7 18 0.6 17 −1 0 1 2 3 4 −1 0 1 2 3 4 World output Interest rate 4 % dev. from initial ss 0.1 2 0 percent 0 −2 −0.1 −4 Monetary union Tradable good Flex. wage Non-tradable good −6 −0.2 −1 0 1 2 3 4 −1 0 1 2 3 4 years years 30
Impact response across the NFA distribution Current account/GDP Output of tradables change from initial steady state 15 % deviation from initial ss B 0 < − k ′ 15 10 10 5 20th 50th p erc. p erc. 5 0 20th 50th 0 −5 p erc. p erc. −10 −5 −1 −0.5 0 0.5 1 −1 −0.5 0 0.5 1 Wealth at the start of the transition: B 0 Wealth at the start of the transition: B 0 Consumption of tradables Output of non-tradables 5 5 % deviation from initial ss % deviation from initial ss 0 0 20th 50th −5 p erc. p erc. 20th 50th −5 −10 p erc. p erc. −15 −10 −20 −15 −25 −30 −20 −1 −0.5 0 0.5 1 −1 −0.5 0 0.5 1 Wealth at the start of the transition: B 0 Wealth at the start of the transition: B 0 31 Production of non-tradables
Outline A model of international deleveraging Deleveraging with flexible wages Deleveraging in a monetary union with nominal wage rigidities The zero lower bound Policy experiments 32
The zero lower bound ◮ Define ˆ R N as the nominal interest rate consistent with t the inflation target � � ˆ ◮ Now monetary policy is given by R N R N t = MAX t , 1 ◮ During period 0, the price of the tradable good has to fall to guarantee market clearing ◮ Two effects ◮ Employment in the tradable sector decreases ◮ Fisher’s debt-deflation: the real debt burden increases 33
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