Sovereign Debt and Financial Crisis

October 18-19, 2013
Sebnem Kalemli-Ozcan of University of Maryland, and Carmen Reinhart and Kenneth Rogoff of Harvard University, Organizers

Óscar Jordá, Federal Reserve Bank of San Francisco; Moritz Schularick, University of Bonn; and Alan Taylor, University of California at Davis and NBER

Sovereigns versus Banks: Credit, Crises, and Consequences (NBER Working Paper 19506)

Two separate narratives have emerged in the wake of the global financial crisis. One speaks of private financial excess and the key role of the banking system in leveraging and deleveraging the economy. The other emphasizes the public sector balance sheet over the private, and worries about the risks of lax fiscal policies. Jordá, Schularick, and Taylor study the co-evolution of public and private sector debt in advanced countries since 1870. They find that in advanced economies financial stability risks have come from private sector credit booms and not from the expansion of public debt. However, they find evidence that high levels of public debt have tended to exacerbate the effects of private sector deleveraging after crises, leading to more prolonged periods of economic depression. Fiscal space appears to be a constraint in the aftermath of a crisis, then and now.

Jack Favilukis, London School of Economics, and Sydney Ludvigson and Stijn Van Nieuwerburgh, New York University and NBER

Foreign Ownership of US Safe Assets: Good or Bad? (NBER Working Paper 19917)

The last 20 years have been marked by a sharp rise in international demand for U.S. reserve assets, or safe stores-of-value. Favilukis, Ludvigson, and Van Nieuwerburgh argue that these trends in international capital flows are likely to be a boon for some (by a lot) but a bane for others (by less). Conversely, a sell-off of foreign government holdings of U.S. safe assets could be tremendously costly for some individuals, while the possible benefits to others are several times smaller. In a general equilibrium lifecycle model with aggregate and idiosyncratic risks, the authors find that the young and oldest households are likely to benefit substantially from a capital inflow, but middle-aged savers may suffer because they are crowded out of the safe bond market and exposed to greater systematic risk in equity and housing markets. In some states, the youngest working-age households and the oldest retired households would be willing to give up 2.0 to 2.8 percent of lifetime consumption in order to avoid just one year of a typical annual decline in foreign holdings of the safe asset. Middle-aged savers could benefit from an outflow, but they do so by an amount that is typically one-tenth of the magnitude of the losses to the youngest and oldest households. Under the veil of ignorance, a newborn would be willing to give up 18 percent of lifetime consumption to avoid a large capital outflow.

Galina Hale, Federal Reserve Bank of San Francisco, and Maurice Obstfeld, University of California at Berkeley and NBER

The Euro and the Geography of International Debt Flows (NBER Working Paper 20063)

Greater financial integration between core and peripheral European Monetary Union (EMU) members had an effect on both sets of countries. Lower interest rates allowed peripheral countries to run bigger deficits, which inflated their economies by allowing credit booms. Core EMU countries took on extra foreign leverage to expose themselves to the peripherals. The result has been asset-price bubbles and collapses in the periphery, area-wide banking crisis, and sovereign debt problems. Hale and Obstfeld analyze the geography of international debt flows using multiple data sources and provide evidence that core EMU countries increased their borrowing from outside of the EMU and their lending to the EMU periphery.

Fabrizio Balassone, Maura Francese, and Angelo Pace, Bank of Italy

Economic Performance in a High Debt Country: the Case of Italy

Balassone, Francese, and Pace examine the relationship between the dynamics of government debt-to-GDP ratio and economic performance in Italy from 1861 to 2007. They use both empirical analysis (based on a standard production function) and a narrative approach. The empirical results highlight a generally negative link between public debt and GDP growth which is stronger for the foreign component of debt before World War I. The authors focus on the different reaction of per capita GDP growth to the debt ratio observed in the years around two local peaks of the debt ratio at the turn of the past two centuries: 1880–1913, when the negative correlation between debt and growth appears to be particularly strong; and 1985–2007, when the correlation appears to break down when debt starts declining. Differences in debt composition (domestic versus foreign) and in capital accumulation patterns in the two periods have a bearing on the respective growth trajectories. The descriptive analysis of fiscal policy provides important complementary evidence and suggests that the timing of fiscal consolidation as well as the size and composition of the budget are additional relevant explanatory factors.

Graciela Kaminsky, George Washington University and NBER, and Pablo Vega-Garcia, George Washington University

Varieties of Sovereign Crises: Latin America, 1820-1931 (NBER Working Paper 20042)

Sovereign debt defaults and renegotiations have been the bread and butter of Latin American countries since the first defaults in the 1820s. During the first period of financial globalization (1820–1931) there were 67 defaults, with countries as rich as Argentina and as poor as Bolivia all defaulting at least once. What can we learn from this first period of financial globalization? Kaminsky and Vega-García create an anatomy of debt defaults, renegotiations, investors' losses, and the re-entering into international capital markets and links this anatomy to the economic and financial evolution of the global economy, the financial centers, and the periphery.

Mark Aguiar, Princeton University and NBER; Manuel Amador, University of Minnesota and NBER; and Emmanuel Farhi and Gita Gopinath, Harvard University and NBER

Coordination and Crisis in Monetary Unions (NBER Working Paper 20277)

Aguiar, Amador, Farhi, and Gopinath characterize fiscal and monetary policy in a monetary union with the potential for rollover crises in sovereign debt markets. Member-country fiscal authorities lack commitment to repay their debt and choose fiscal policy independently. A common monetary authority chooses inflation for the union, also without commitment. The authors first describe the existence of a fiscal externality that arises in the presence of limited commitment and leads countries to overborrow; this externality rationalizes the imposition of debt ceilings in a monetary union. They then investigate the impact of the composition of debt in a monetary union, that is the fraction of high-debt versus low-debt members, on the occurrence of self-fulfilling debt crises. They demonstrate that a high-debt country may be less vulnerable to crises and have higher welfare when it belongs to a union with an intermediate mix of high- and low-debt members, than one where all other members are low-debt. This contrasts with the conventional wisdom that all countries should prefer a union with low-debt members, as such a union can credibly deliver low inflation. These findings shed new light on the criteria for an optimal currency area in the presence of rollover crises.

Pablo D'Erasmo, Federal Reserve Bank of Philadelphia and University of Maryland, and Enrique Mendoza, University of Pennsylvania and NBER

Distributional Incentives in an Equilibrium Model of Domestic Sovereign Default (NBER Working Paper 19477)

International historical records on public debt show infrequent episodes of outright default on domestic debt. Reinhart and Rogoff (2008) document these events and argue that they constitute a "forgotten history" in macroeconomics. D'Erasmo and Mendoza develop a theory of domestic sovereign default in which distributional incentives, interacting with default costs, make default part of the optimal policy of a utilitarian social planner. The model supports equilibria with debt subject to default risk in which rising wealth inequality reduces the optimal debt and increases default probabilities and spreads. A quantitative experiment calibrated to European data shows that, in the observed range of inequality in the distribution of bond holdings, the model accounts for one third of the average debt and spreads of about 400 basis points. Default risk reduces sharply the sustainable debt, except when the weights in the government payoff value the utility of bond holders more than their share of the wealth distribution. If the former is sufficiently larger than the latter, the model supports debt ratios similar to European averages exposed to low default probabilities.

Yusuf Soner Baskaya, Central Bank of Turkey, and Sebnem Kalemli-Ozcan

Are Government Bonds Bad for Banks? Evidence from a Rare Fiscal Shock

Baskaya and Kalemli-Ozcan identify the effect of government debt exposure on financial sector performance. They use confidential balance sheet and portfolio data for the universe of banks in Turkey between 1986 and 2012. The identification relies on a natural experiment. The government was hit by a major fiscal shock as a result of the 1999 Marmara earthquake that led to public insolvency. Using a differences-in-differences methodology, the authors compare the performance of banks with high exposure to government debt against the banks with low exposure before and after the earthquake. Banks that held a significant amount of government securities on their balance sheets were hurt relatively more than banks with less exposure. Results are not driven by the extensive margin, that is, the banks that were taken over by the government during the 2001 crisis. The authors rule out alternative stories on selection and customer demand in the Marmara region. Falsification exercises show that government bonds can be bad for banks only when government debt unexpectedly becomes unsustainable.

Carmen Reinhart; Vincent Reinhart, American Enterprise Institute; and Kenneth Rogoff

Debt Hangovers

Cristina Arellano, Federal Reserve Bank of Minneapolis and NBER; Xavier Mateos-Planas, Queen Mary University of London; and Jose-Victor Rios-Rull, University of Minnesota and NBER

Partial Default

Arellano, Mateos-Planas, and Ríos-Rull produce a theory of partial default applicable to sovereign debt. They document that contrary to standard theory, countries always default on only part of their debt and continue to borrow while having debt in arrears. In this model default acts as expensive debt which curtails countries' productive capabilities. Debt in arrears is carried until it is finally repaid. The model is consistent with the large heterogeneity in defaults observed across countries and years.