International Economic Association A non-profit organization with purely scientific aims, the International Economic Association (IEA) was founded in 1950 Its basic purpose is the development of economics as an intellectual discipline, recognizing a diversity of problems, systems and values in the world and taking note of methodological diversities Since its creation, the IEA has sought to fulfil that purpose by promoting mutual understanding among economists through the organization of scientific meetings and common research programmes The publications that comprise the series, are the explorations of these matters discussed, with special attention paid to issues of economies in transition and in the course of development Series Editor: Joseph E Stiglitz Other titles from IEA: LIFE AFTER DEBT The Origins and Resolutions of Debt Crisis Edited by Joseph E Stiglitz and Daniel Heymann INCOME CONTINGENT LOANS Theory, Practice and Prospects Edited by Joseph E Stiglitz, Bruce Chapman and Timothy Higgins TAMING CAPITAL FLOWS Capital Account Management in an Era of Globalization Edited by Joseph E Stiglitz and Refet Gurkaynak THE INDUSTRIAL POLICY REVOLUTION I The Role of Government Beyond Ideology Edited by Joseph E Stiglitz and Justin Lin Yifu THE INDUSTRIAL POLICY REVOLUTION II Africa in the 21st Century Edited by Joseph E Stiglitz, Justin Lin Yifu and Ebrahim Patel THE CHINESE ECONOMY A New Transition Edited by Masahiko Aoki and Jinglian Wu INSTITUTIONS AND COMPARATIVE ECONOMIC DEVELOPMENT Edited by Franklin Allen, Masahiko Aoki, Nobuhiro Kiyotaki, Roger Gordon, Joseph E Stiglitz and Jean-Paul Fitoussi COMPLEXITY AND INSTITUTIONS: MARKETS, NORMS AND CORPORATIONS Edited by Masahiko Aoki, Kenneth Binmore, Simon Deakin and Herbert Gintis CORPORATE SOCIAL RESPONSIBILITY AND CORPORATE GOVERNANCE The Contribution of Economic Theory and Related Disciplines Edited by Lorenzo Sacconi, Margaret Blair, R Edward Freeman and Alessandro Vercelli IS ECONOMIC GROWTH SUSTAINABLE? Edited by Geoffrey Heal KEYNE’S GENERAL THEORY AFTER SEVENTY YEARS Edited by Robert Diman, Robert Mundell and Alessandro Vercelli CORRUPTION, DEVELOPMENT AND INSTITUTIONAL DESIGN Edited by János Kornai, László Mátyás and Gérard Roland MARKET AND SOCIALISM In the Light of the Experience of China and Vietnam Edited by János Kornai and Yingyi Quian INSTITUTIONAL CHANGE AND ECONOMIC BEHAVIOUR Edited by János Kornai, László Mátyás and Gérard Roland INTERGENERATIONAL EQUITY AND SUSTAINABILITY Edited by John E Roemer and Kotaro Suzumura PSYCHOLOCY, RATIONALITY AND ECONOMIC BEHAVIOUR Challenging Standard Assumptions Edited by Bina Agarwal and Alessandro Vercelli MULTINATIONALS AND FOREIGN INVESTMENT IN ECONOMC DEVELOPMENT Edited by Edward M Graham POST-CONFLICT ECONOMIES IN AFRICA Edited by Paul Collier and Augustin Kwasi Fosu STRUCTURAL REFORM AND MACROECONOMIC POLICY Edited by Robert M Solow THE PAST, PRESENT AND FUTURE OF THE EUROPEAN UNION Edited by Alan V Deardorff LATIN AMERICAN ECONOMIC CRISES Trade and Labour Edited by Enrique Bour, Daniel Heymann and Fernando Navajas ADVANCES IN MACROECONOMIC THEORY Edited by Jacques H, Drèze EXPLAINING GROWTH A Global Research Project Edited by Gary McMahon and Lyn Squire TRADE, INVESTMENT, MIGRATION AND LABOUR MARKET ADJUSTMENT Edited by David Greenaway, Richard Upward and Katherine Wakelin INEQUALITY AROUND THE WORLD Edited by Richard B Freeman International Economic Association Series Standing Order ISBN 978–0–3337–1242–9 (Hardback) 978–0–3338–0330–1 (Paperback) You can receive future titles in this series as they are published by placing a standing order Please contact your bookseller or, in case of difficulty, write to us at the address below with your name and address, the title of the series and one of the ISBNs quoted above Customer Services Department, Macmillan Distribution Ltd, Houndmills, Basingstoke, Hampshire RG21 6XS, England Life After Debt The Origins and Resolutions of Debt Crisis Edited by Joseph E Stiglitz University Professor, Columbia University, USA and Daniel Heymann Professor of Economics, University of Buenos Aires, Argentina © International Economic Association 2014 Softcover reprint of the hardcover 1st edition 2014 978-1-137-41146-4 All rights reserved No reproduction, copy or transmission of this publication may be made without written permission No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6-10 Kirby Street, London EC1N 8TS Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988 First published 2014 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010 Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries ISBN 978-1-137-41147-1 ISBN 978-1-137-41148-8 (eBook) DOI 10.1057/9781137411488 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin A catalogue record for this book is available from the British Library A catalog record for this book is available from the Library of Congress Contents List of Figures vii List of Tables viii Foreword and Acknowledgements ix Notes on the Contributors xii Introduction Joseph E Stiglitz and Daniel Heymann Part I Analytical Issues 1.1 Crises: Principles and Policies Joseph E Stiglitz 1.2 Comment on “Crises: Principles and Policies” by Joseph E Stiglitz Martin Guzman 43 80 Part II Debt Crises: Varieties of Experiences 2.1 The Latin American Debt Crisis in Historical Perspective José Antonio Ocampo 2.2 Comment on “The Latin American Debt Crisis in Historical Perspective” by José Antonio Ocampo Pablo Sanguinetti 2.3 What Have the Crises in Emerging Markets and the Euro Zone in Common and What Differentiates Them? Roberto Frenkel 2.4 Comment on “What Have the Crises in Emerging Markets and the Euro Zone in Common and What Differentiates Them?” by Roberto Frenkel Ricardo Bebczuk 2.5 From Austerity to Growth in Europe: Some Lessons from Latin America Stephany Griffith-Jones 2.6 Comment on “From Austerity to Growth in Europe: Some Lessons from Latin America” by Stephany Griffith-Jones Hernán D Seoane v 87 116 122 142 145 171 vi Contents Part III Debt Defaults: Costs and Restructuring Games 3.1 Strategic Behavior in Sovereign Debt Restructuring: Impact and Policy Responses’ Rohan Pitchford and Mark L.J Wright 3.2 Comment on “Strategic Behavior in Sovereign Debt Restructuring: Impact and Policy Responses” by Rohan Pitchford and Mark L.J Wright Federico Weinschelbaum 3.3 “Sovereign Debt Restructuring: The Road Ahead” Benu Schneider 3.4 Commentary on “Sovereign Debt Restructuring: the Road Ahead” by Benu Schneider Fernando Navajas 179 191 193 221 Part IV Dealing with Crises: Instruments and Policies 4.1 Saving the Euro: Self-fulfilling Crisis and the “Draghi Put” Marcus Miller and Lei Zhang 4.2 Comments on “Saving the Euro: Self-fulfilling Crisis and the ‘Draghi Put’ ” by Marcus Miller and Lei Zhang Alfredo Schclarek Curutchet 4.3 “GDP-linked Bonds and Sovereign Default” David Barr, Oliver Bush and Alex Pienkowski 4.4 Comment on “GDP-Linked Bonds and Sovereign Default” by David Barr, Oliver Bush and Alex Pienkowski Enrique Kawamura 4.5 “Multiple Choices: Economic Policies in Crisis” Daniel Heymann and Axel Leijonhufvud 4.6 Comment on “Multiple Choices: Economic Policies in Crisis” by Daniel Heymann and Axel Leijonhufvud Jorge Carrera Index 227 242 246 276 281 309 317 List of Figures 2.1.1 Economic crises of Latin America 1820–2008: A Number of countries on a currency, external debt, or banking crisis; B Number of country/years in crisis by period 2.1.2 Economic growth and trade balance 2.1.3 Net resource transfer (% of GDP at current prices) 2.1.4 A Real interest rates; B Real non-oil commodity prices (1980=100) 2.1.5 Dynamics of the Latin American external debt (% of GDP and exports) 2.1.6 A Comparison between the crises of the 1930s and 1980s: external indicators: A Purchasing power of exports; B Trade Balance as % of exports (vs 1929 and 1980) 2.1.7 A comparison between the crises of the 1930s and 1980s: GDP and per capita GDP: A GPD; B Per capita 2.1.8 Public sector finances and inflation (simple averages), A Central government deficit; B Median rate of inflation 2.5.1 Additional proposed EIB and EU growth expenditure program (billions of Euros) 2.5.2 Estimates of the European GPD growth with and without investments pact 2.6.1 GDP volatility, selected Latin American countries 2.6.2 GDP volatility, selected European countries 4.1.1 Spreads and debt to GDP ratio in the Euro Zone (2001Q1–2011Q3) 4.1.2 Spreads and debt to GDP ratio in stand-alone countries (2000Q1–2011Q3) 4.1.3 Self-fulfilling partial default 4.1.4 Avoiding the default equilibrium with the Draghi Put 4.1.5 Effects of OMT 4.1.6 BEFORE: investors holds sovereign bonds – but are prone to switch 4.1.7 AFTER: stability and growth fund pools sovereign debt – and diversifies types of bond 4.3.1 Debt dynamic phase diagram 4.3.2 Real GDP growth outturns, 1870–2008 4.3.3 Expected return on conventional and GDP-linked bonds 4.3.4 Output growth and the change in the primary balance, conventional bonds 4.3.5 Output growth and the change in the primary balance, GDP bonds vii 89 92 95 97 99 101 107 109 155 158 174 175 231 231 234 236 236 238 239 258 258 263 267 267 List of Tables 2.1.1 2.5.1 Gross Fixed Capital Formation (% of GDP) Original Brady/exchange issue amounts (US$ bn) and multilateral debt relief agreements with commercial banks 2.5.2 Additional proposed EIB and EU growth expenditure programme (in € billions) 2.5.3 Effect of Investment Pact on GDP and employment 2.5.4 GDP in £ billion, 2010 prices under two scenarios 4.1.1 The debtors’ dilemma: An engine of austerity? 4.1.2 Different types of stability bonds 4.1.3 Balance sheet of SPV 4.3.1 Model calibration 4.3.2 Sensitivity of parameter values 4.3.3 Debt limits under various coefficients of relative risk aversion 4.3.A1 Summary of key model outputs viii 93 149 155 159 166 237 238 239 255 257 262 272 Foreword and Acknowledgements This volume collects papers and comments presented in the Roundtable on Debt Crises and their Resolution organized in Buenos Aires, Argentina, in August 2012 by the International Economic Association (IEA) jointly with the Argentine Association of Political Economy (AAEP) and the Faculty of Economic Sciences of the University of Buenos Aires (FCE- UBA), with the sponsorship of the Argentine Ministry of the Economy, the Institute for the Integration of Latin America and the Caribbean (INTAL , IDB) and the National University of Córdoba (UNC) The project of the conference derived from the recognition that debt crises continue to pose substantial analytical challenges, and that a discussion of the topic would be particularly pertinent at the time and place of the meeting The financial turbulences and macroeconomic contractions of central economies in recent years have shown that high wealth and state-of-the-art institutions not provide immunity against debt-originated disturbances Europe, in particular, is still dealing with difficultywith the crises in its periphery, which have proven to be highly costly, not only in terms of economics, but also in terms of the broader burdens placed on society; and it has yet to find ways to restore growth in the region as a whole Latin America, for its part, has a long history of crises and more or less strong recoveries, which offer a rich experience on which to contrast analytical propositions about the prevention, causes, and resolution of debt crises anddiscuss policy proposals, with due regard for the specificities of each episode Argentina, in particular, offers an example of one of the themes of the conference: overcoming a crisis may be helped considerably, in some cases, by a restructuring of financial contracts aimed towards the sustainability of future obligations when the volume of outstanding debts has become excessive Argentina managed its way through a very deep crisis, using as part of its set of instruments a large-scale redefinition of debt obligations, public and private After dramatic episodes, there was indeed life after debt; at the same time, the country´s recent economic performance hasalso shown that a lighter debt burden, while necessary,may certainly not be sufficient to determine a stable macroeconomic trend of solid growth In calling for the Roundtable, we thought it would be particularly useful to think about the European crisis, then in its early days, from the vantage point of the lessons that might be learned from the experiences of others, and in particular that of Argentina By their very nature, debt crises are systemic events, driven by intricate interactions of individual and collective behaviors This book looks both at crises which originate in the public sector and at those that arise from excessive indebtedness in the private We this for good reason: one kind of debt crisis ix 304 10 11 Life After Debt representative agent models is, of course, even more misleading Marginal rates of substitution and transformation are out of line almost everywhere and the market will not work to equalize them In high inflations, the variability of relative prices rises dramatically for very similar reasons Cf Heymann and Leijonhufvud (1995) A common practice in the market for automobiles in Argentina, especially in periods of high inflation or financial disturbance, was to buy cars through a system of “savings for specific purposes”, where the buyer pre-paid a number of installments (adjusted with the price of a new vehicle) before delivery When signing the contract, a purchaser was both signaling the demand for the good and providing financing for production Whatever the problems of the scheme, the transformation of savings into future productive decisions was more or less automatic The argument could be rephrased with some changes for the opposite case of an increase in the demand for current consumption in a near-full employment economy If asset markets keep the interest rate “too low”, the planned demand for current consumption will have to compete for resources with a “too high” investment The consequent “forced saving” would then cause misallocations and possibly lead to a dangerous expansion of indebtedness But asset price bubbles will be discussed in what follows We are assuming that these credit constraints are a given feature, as used to be the case in the past, and is still the case in a variety of economies At this point, we disregard the potential flexibility, and also the potential amplification effects, brought about by changes in consumer credit The qualification matters here because of the common argument that there cannot be default by a government whose outstanding debt is denominated in its own currency While the contractual obligation as written can always be met by producing enough money, this may be far from validating the real terms originally expected The Central European hyperinflations after World War I were certainly considered a form of default even if these governments fully repaid the nominal values of their debts The mere promise of monetization will not sustain the demand for bonds The misbehavior of mechanical trading strategies on a particular day is a relevant example Suppose it produces a sudden fall in stock prices This noisy volatility is harmful – it causes confusion and creates random redistributions among agents who were buying or selling at the time However, once it is known that this was an occasional, non-systematic event, perceptions of the wealth and creditworthiness of agents, who were not actually “in the market”, will not be affected and real repercussions will be of little consequence The size of buffer stocks of liquid assets held throughout the system should be understood as subsumed under this heading Kiyotaki and Moore (1997), Bernanke and Gertler (1989), Brunnermeier and Pedersen (2009), Allen, Carletti and Gale (2009), Shin (2010), Mehrling (2011), Geanakoplos (2010) are contributions to the large literature on these issues The most prominent critics of the “Greenspan put” have been George Soros and the former chief economist of the BIS, William White But the role of monetary easing in the build-up of the housing bubble in the US remains a matter of controversy Cf for example, Bernanke (2011) and Mees (2011) The reference is to Keynes’ Treatise (1930), where he discussed the possibility of the central bank using absolutely all its powers in an emergency Daniel Heymann and Axel Leijonhufvud 305 12 One example: in an economy that has run large current account deficits and incurred excessive debts abroad, installations to produce non-traded goods may have to be scrapped even while resources are lacking in traded goods sectors 13 A small scene remembered from the Argentine crisis of 2001/2002 comes to mind Through the 1990s, Argentina operated a currency board monetary system with a one-to-one exchange rate against the dollar Vast sums of bank loans and deposits and contracts of all kinds were denominated in dollars This convertibility system eventually proved unsustainable and collapsed At that juncture, the government transformed dollar-denominated bank loans and deposits (at different rates) into pesos However, it left contracts outside the banking system to be renegotiated by the parties involved One day two street demonstrations took place simultaneously close to the same government building One group consisted of people who had lent dollars on mortgages and who now demanded to be repaid in full in dollars; the other group consisted of people who had borrowed in dollars and asked for debt reduction or relief of some sort A TV reporter brought together a representative of each group The spokesman of the lenders argued that contracts should be fulfilled – no more, no less – and since they had delivered dollars in good faith, they deserved to get them back The spokesman for the borrowers explained that, when the loans were entered into, the convertibility law guaranteed the parity between pesos and dollars; now wage-earners in pesos were completely unable to repay in dollars and it would be a great injustice to take away the homes of families because of an economic crisis they had had no responsibility for causing The reporter asked the two spokesmen to comment on the each other’s argument “The lender is right”, said the borrower, “a contract is a contract Naturally, lenders want to recover their money as agreed But we simply cannot be asked to repay out of our depreciated incomes.” The lender answered: “The borrower is right Who could force someone to make payments in dollars after the devaluation we have had? People not earn enough for their daily expenses But our claim is completely legal and why should we be discriminated against simply because we lent our savings to countrymen instead of hoarding them or sending them abroad? “Well, then,” asked the reporter, “what should be done?” The two spokesmen agreed: “Someone should come up with the difference.” But, of course, no such deus ex machina existed The collapse of the Argentine convertibility system was a unique event But the story tells a lesson that applies to all great credit crises The responses of the two parties expressed the shared, firmly held social values of ordinary people But those values dictated an impossible outcome No feasible fair solution existed 14 Shops posting signs declaring “Closed for the Lack of Prices” is an example discussed in our High Inflation (1995) 15 The inflation tax is borne particularly by low income groups that lack the means to avoid it 16 Fiscal stabilizations may sometimes be consistent with rising activity also in economies that are not suffering from high inflation Although the evidence on expansionary fiscal adjustments remains under debate (cf Giavazzi and Pagano, 1990; Alesina and Ardagna, 2010; IMF, 2011; Perotti, 2011), it is understandable that an agreement to reduce the budget deficit when the fiscal position is in doubt can reduce uncertainty and lift pressures on credit markets 17 In a related context, Alvarez and Dixit (2013) have used a calibrated model to analyze the incentives to abandon a monetary union They suggest that, while the 306 18 19 20 21 22 23 Life After Debt option value of delay may be relevant, the magnitude of the effect is probably small But the decision to suspend payments on the public debt is hardly a cold-blooded optimization based on some postulated normal probability distribution Decision makers are apt to put considerable weight on the possibility of a “catastrophic” outcome; but they might also cling to the hope of “good news” that would make the status quo sustainable after all The chances of repayment are quite different before and after restructuring Estimating the size of “haircuts” becomes a far from trivial problem Which rate is the right one for discounting the repayments promised prior to restructuring? This discount rate ought to reflect the likelihood prior to the default that the debt would not be serviced in full But this likelihood certainly fluctuated widely before and during the crisis so what date to use for reference is anything but clear Moreover, the expectations of the parties embodied in observed market rates were not necessarily “reasonable.” Clearly, this problem does not have a solution that will command general assent But it is also clear that, if the same rate is used for both pre- and post-restructuring, the loss suffered by creditors will be overestimated (cf Sturzenegger and Zettelmeyer, 2005) In what may be the worst case, the self-denying provision may even induce procyclical behavior, as is the case, most notably, with balanced budget amendments that force governments to amplify fluctuations in private sector expenditures Credibility and flexibility can be complementary Economies where inflation expectations have been kept low and steady can afford exchange rate variability as shock absorber, because of its moderate impacts on prices and the absence of debt deflation effects as long as the credit system is not “dollarized” When the government is seen to be solvent it is also easier to expand fiscal policies in recession It would also create a diseconomy of scale that could be of some help with the “too big to fail” problem Executives in one department of a bank would have a vital interest in the risks taken on in other departments and conflicts of this kind For the early history of liability in banking, see White (1995) It might help a bit that the proposal would include some bank deposit substitutes in the nominal magnitude controlled by the central bank References Aguiar, M and Gopinath, G (2007) “Emerging Market Business Cycles: the Cycle is the Trend,” Journal of Political Economy, vol 115, pp 69–102 Alesina, A and Ardagna, S (2010) “Large Changes in Fiscal Policy,” in Tax Policy and the Economy, vol 24, Jeffrey R Brown (ed.) (Chicago: University of Chicago Press), pp 35–68 Allen, F., Carletti, E and Gale, D (2009) “Interbank Market Liquidity and Central Bank Intervention,” Journal of Monetary Economics, vol 56, no 5, pp 639–52 Alvarez, F and A Dixit (2013) A Real Option Perspective on the Future of the Union, Working Paper Available online at https://www.princeton.edu/~dixitak/home/EuroCollapse pdf Bernanke, B (2011) The Effects of the Great Recession on Central Bank Doctrine and Practice, Federal Reserve Bank of Boston 56th Economic Conference, Boston, MA Bernanke, B and Gertler, M (1989) “Agency Costs, Net Worth, and Business Fluctuations,” American Economic Review, vol 79, no pp 14–31 Daniel Heymann and Axel Leijonhufvud 307 Boz, E., Daude, C and Durdu, C (2008) Emerging Market Business Cycles: Learning about the Trend, FRB International Finance Discussion Paper 927 Brunnermeier, M and Pedersen, L (2009) “Market Liquidity and Funding Liquidity,” Review of Financial Studies, vol 22, no 6, pp 2201–38 Cruces, J and Trebesch, C (2011) “Sovereign Defaults: The Price of Haircuts,” CESifo Working Paper Series no 3604 Federal Deposit Insurance Corporation (2013) Text of the Final Common Rules Available online at http://www.fdic.gov/regulations/reform/volcker/rule.html Geanakoplos, J (2010) “Solving the Present Crisis and Managing the Leverage Cycle,” Federal Reserve Bank of New York Economic Policy Review, pp 101–31 [CFP 1305] Giavazzi, F and Pagano, M (1990) “Can Severe Fiscal Contractions be Expansionary? Tales of Two Small European Countries,” NBER Macroeconomic Annual 1990 (Cambridge, MA: MIT Press) Gurley, J and Shaw, E (1960) Money in a Theory of Finance (Washington, DC: Brookings Institution Haldane, A and May, R (2011) “Systemic Risk in Banking Ecosystems,” Nature, no 469, January 20, pp 351–5 Heymann, D and Leijonhufvud, A (1995) High Inflation (Oxford and New York: Clarendon Press) Heymann, D and P Sanguinetti (1998) “Business Cycles from Misperceived Trends,” Economic Notes, vol 27, no 2, pp 205–32 Heymann, D., Kaufman, M and Sanguinetti, P (2001) “Learning about Trends: Spending and Credit Fluctuations in Open Economies,” in A Leijonhufvud (ed.), Monetary Theory as a Basis for Monetary Policy (New York: Palgrave Macmillan) House of Commons (2013) The Independent Commission on Banking: The Vickers Report Available online at www.parliament.uk/briefing-papers/sn06171.pdf International Monetary Fund (2011) From Stimulus to Consolidation: Revenue and Expenditure Policies in Advanced and Emerging Countries, Fiscal Affairs Department (Washington, DC: International Monetary Fund) Jonung, L (2009) The Swedish Model for Resolving the Banking Crisis of 1991–1993: Seven Reasons Why it Was Successful, DG ECFIN (Brussels: European Commission) Keynes, J.M (1930) A Treatise on Money (New York: Harcourt Press) King, M (2005) “Monetary Policy: Practice ahead of Theory,” Bank of England and City University of London, May 17 Available online at http://www.bankofengland.co.uk/ archive/Documents/historicpubs/speeches/2005/speech245.pdf Kiyotaki, N and Moore, J (1997) “Credit Cycles,” Journal of Political Economy, vol 105, no pp 211–48 Koo, R (2003) Balance Sheet Recession: Japan´s Struggle with Uncharted Economics and its Global Implications, first edition (New Jersey: Wiley Publishing) Leijonhufvud, A (1973) “Effective Demand Failures,” The Swedish Journal of Economics, vol 75, no 1, pp 27–48 Leijonhufvud, A (2010) “A Modest Proposal,” VoxEU, January 23 Available online at http://www.voxeu.org/article/modest-proposal-double-liability-bankers Leijonhufvud, A (2011) “Shell Game: Zero-interest Policies as Hidden Subsidies to Banks,” VoxEu, January 25 Available online at http://www.voxeu.org/article/21stcentury-shell-game-how-bankers-play-and-taxpayers-pay Mees, H (2011) Lost in Transmission, VoxEu, May Available online at http://www voxeu.org/article/lost-transmission Mehrling, P (2011) The New Lombard Street: How the Fed Became the Dealer of Last Resort (Princeton, NJ and Oxford: Princeton University Press) Minsky, H (1975) John Maynard Keynes (New York: Columbia University Press) 308 Life After Debt Patinkin, D (1961) “Financial Intermediaries and the Logical Structure of Monetary Theory,” American Economic Review, vol 51, no 1, pp 95–116 Perotti, R (2011) The Austerity Myth: Gain without Pain?, NBER Working Paper no 17571 Reinhart, C.M and K.S Rogoff (2011) This Time is Different: Eight Centuries of Financial Folly (Princeton, NJ: Princeton University Press) Shin, H.S (2010) Risk and Liquidity (Oxford: Oxford University Press Sturzenegger, F and Zettelmeyer, J (2005) Haircuts: Estimating Investors Losses in Sovereign Debt Restructuring, 1998–2005 IMF Working Paper no 05/137, Research Department (Washington, DC: IMF) White, L (1995) Free Banking in Britain, 2nd edn (London: Institute of Economic Affairs) 4.6 Comment on “Multiple Choices: Economic Policies in Crisis” by Daniel Heymann and Axel Leijonhufvud Jorge Carrera This is a very interesting paper discussing policy dilemmas during a crisis I will make some comments and deal with extensions which, in my opinion, complement the analysis developed by the authors A central concept used in this paper is the idea of a contracts web in which different nodes interplay at different levels A first thing to say is that widespread interaction among international systemic nodes makes the current crisis far different from comparable Latin American or Asian episodes, or even the crises experienced by Japan or Sweden In the current event, we see a stronger incidence of both sovereign agents and global financial institutions: as a consequence, it seems much more evident now that there are huge problems derived from the lack of well-established and efficient “rules of the game” specially those to be applied in cases of generalized default or “default avalanches” as the authors called it in the paper Hence, when the main actions to be taken during a crisis not correspond exclusively to the national level but to the international one, the lack of such rules makes it more likely that these nodes globally spread instability, boost financial fragility and generate coordination failures Increased importance of critical nodes and higher interconnectivity also imply long and lasting chain reactions to defaults 4.6.1 Balance sheet recessions and full-fledged balance sheet (debt) crisis The authors state that a good way to characterize the current situation is as a balance sheet recession It would be interesting to explore the conditions that make a balance sheet recession remain as such, and the circumstances under which it might evolve into a full-fledged debt crisis 309 310 Life After Debt A balance sheet recession takes place where many highly indebted agents in the economy start an aggressive process of deleveraging at the same time A balance sheet recession would turn into a full-fledged debt crisis (debt deflation) if private sector contraction is not counterbalanced by another sector’s spending In this regard, Richard Koo (2011)1 stresses that fiscal policy may offset private sector deleveraging, avoiding a debt-deflation scenario But cleaning balance sheets may take years and public deficit might not be enough to stimulate economic growth Indeed, the authors highlight that the USA is probably the only example of a balance sheet recession which was successfully solved by public deficit in the times of World War II They remark that growth is the key factor in making federal debt sustainable However, I would like to stress Reinhart and Kirkegaard’s point (2012)2 that debt-to-GDP ratios have been reduced, as evidenced throughout history, by: (a) economic growth; (b) fiscal adjustment and austerity plans; (c) explicit default or restructuring debt; (d) “surprise” inflation; and (e) financial repression In particular, they emphasize that negative real interest rates over a long period played a key role in the US recovery after World War II This rationale raises doubts about the likelihood of recovering from a balance sheet recession by resorting to fiscal policy only With regard to the role played by the external sector, external surplus could be a complementary exit for concurrent deleveraging by households and companies; this is particularly in the case where it is unfeasible to rest solely on public deficit However, external surplus may be acknowledged as a compensating tool as long as we are not dealing with a global crisis where other important countries are also trying to deleverage 4.6.2 International dimension: the role of interdependence and coordination This is a crisis that started at the center of the system, which implies that mechanisms of shock transmission and contagion are at play on a worldwide scale Any single crisis may potentially have more disruptive effects within a global context because of increased external interconnections and the weaker legal and economic protection of these links We are not absolutely sure whether interdependence tends to be stabilizing or destabilizing at the global level For instance, international trade restrictions can amplify the effects of an initial negative shock but, as discussed by Krugman (2008):3 the international financial multiplier is currently the dominant channel which reinforces negative feedbacks In this last result, the Highly Leveraged Financial Institutions (Hedge Funds) play a pivotal role in spreading crisis out of the continuous need to rebalance their balance sheets Jorge Carrera 311 Then, the picture of the current world situation calls for a model with several countries facing a sequence of shocks that affect each country differently In addition, policy responses may also be heterogeneous due to political reasons, different beliefs or preferences, or nationally oriented policymaker priorities – which may entail a “beggar-thy-neighbor” behavior Coordination in the web of contracts cannot be taken for granted as a spontaneous outcome, since each country is exposed to a different type of shock in terms of timing and intensity; and, of course, reaching a policy agreement on the development of a necessary policy mix is such a hard task, even in the light of quite similar situations 4.6.3 Critical nodes in the web I: Issues concerning sovereign default Sovereign agents and the respective contracts they enter into are a fundamental part of the web of contracts, but they are particularly complex A distinctive feature of the global scenario which has been in place since 2007 is the interface between fiscal authorities and financial markets The role of sovereign debt for financial markets is crucial considering its magnitude in terms of notional value But the lack of common accepted, stable and clear mechanisms to deal with sovereign default poses a serious challenge for the whole web of contracts The paper includes some interesting considerations in this regard Political economy concerns related to the decision making of sovereign default are presented in the paper with remarkable clarity The authors assert that default is usually declared after the economy has suffered substantial pains trying to avoid it, which is a clear signal of unfeasibility to meet financial obligations They also describe different forms in which default is connected with other major economic changes I would like to point out that a delay in taking a default decision, when predictable, reduces its effectiveness Then, the role played in these circumstances by International Financial Institutions (IFIs) is worth mentioning: they usually facilitate private deleveraging during financial stress and capital outflows However, when debt restructuring actually occurs, a high portion of a debtor country’s financial obligations has already been considered as unsuitable for defaulting (IFIs obligations) This leaves less room for an aggressive haircut which would remove high-debt growth restrictions Hence, an early debt restructuring scheme is a key element that international financial rules should include, but typically this is not in the menu of international institutions Additionally, private involvement in sovereign default restructuring processes requires a stronger institutional setup than is currently in place The 312 Life After Debt recent proliferation of Collective Action Clauses is far from being enough in order to guarantee an efficient debt restructuring process when necessary 4.6.4 Critical nodes in the web II: Global financial institutions and macroprudential regulation The authors stress that there are some nodes in the web of contracts which are particularly important as they are capable of producing an avalanche of broken promises and long chain reactions to default Several of these nodes are financial institutions In banking terms, a well-known problem is posed by “too big to fail” institutions, which evidently are also “too big to be regulated.” These nodes, called Systemically Important Financial Institutions (SIFIs), are even more dangerous when we consider their international dimension The global dimension of SIFIs means that regulations should be designed at the international level Indeed, most of the financial regulations that deal with SIFIs have been formulated without the direct influence of national authorities and under the umbrella of the self-regulation of markets (market discipline) The delegation of the regulatory design has resulted in less regulation for SIFIs but, above all, a fertile ground for an increasing diversification of domestic risk Basel rules have been homogeneous everywhere, facilitating the external expansion of SIFIs, that is, transforming them into global SIFIs The original Basel rules did not stop or prevent crises; worse still, perhaps the standardization of risk management might have contributed to its dissemination Current solutions (Basel II and III) consider interesting points, but share with their antecessor the inspirational view of minimizing policy intervention and the regulation of the system The problem arises from regulators’ institutional inertia and sunk intellectual capital As I have already mentioned, we face institutions that are too big to be regulated or controlled Which institutions control the big multinational banking institutions? To date we have a series of regulators, one for each subsidiary, and a regulator at home Each one supervises different parts of the bank No one has a complete view of the whole institution for supervisory purposes The so-called “College of Supervisors” is an ad hoc meeting at which country supervisors of one international bank are supposed to share information But, in general, home regulators tend to protect their own national banks Regulatory arbitrage is a key threat posed by global systematically important financial institutions (GSIFIs), given the preference of most countries for their “own” big systemic banks In addition, this type of college has no enforcement power In other words, we have very powerful global banks but no institution that is sufficiently empowered to supervise them In this scenario, some countries, specially emerging ones, might choose to “ring fence” subsidiaries This is a flawed substitute of global regulation Jorge Carrera 313 The authors are rather skeptical about the ability to “unscramble an omelet” once it has been cooked, certainly, making reference to the separation of commercial and investment functions of banks at the national level I would like to add that, at the international level, this omelet is all the more messy since there is no “chef” ready to unscramble and cook it anew 4.6.5 The incentives of regulators The relationship between innovators and regulators in the financial system is problematic There is more than one concern with monetary and reputational incentives A financial innovator is seen as a Schumpeterian agent every time a “new discovery” is under way In respect of intervention a regulator has little room for maneuver If it takes action in some restrictive way, it will be blamed for putting a spoke in the wheel On the contrary, when a bubble bursts, supervisors and central banks are urged to act immediately in order to prevent higher costs Finally, another reason for avoiding “too big to fail” banks is that their rescue increases political economy problems If a central bank or a Treasury were to save a big bank before it shows clear signs of distress, the political costs would be tremendous If the same bank were saved after the parliament and the society at large realized that the bank was in trouble, such a decision would cost more money and would be less likely to succeed 4.6.6 Financial liberalization and innovation as common denominator of different debt crisis: reforming the international financial architecture The experiences of Argentina (in 2001–02), the US (the Great Depression), the UK, Greece, Ireland, Portugal, Spain, among other countries, stand for different types of debt crisis All of them have something in common: they had been preceded by a period of financial liberalization and/or financial innovation, a “new era” of credit availability for credit-constrained agents In most of these cases, external financial openness fueled credit boom and a stronger contraction during the subsequent crisis This goes far beyond traditional transmission channels of distress In addition to the different lessons that can be drawn from the paper, I think there are some relevant questions to be raised: What is the optimal or adequate degree of financial repression or, better, domestic macroprudential regulation? Especially in respect of innovation and internal connections among different parts of the financial system 314 Life After Debt What is the optimal or adequate degree of capital controls? Should capital controls be part of an international framework such as Bretton Woods? Which is the best mechanism to regulate and supervise GSIFIs? Do emerging countries need codes of good practices in exchange rate management, international reserve accumulation, and capital controls as those encouraged by the IMF? Regarding the treatment of financial innovation, it could profitable to learn from the experience of other fields in which innovation has immeasurable positive or negative externalities, like pharmacology, biological sciences, weapons, and so on In these fields, innovators have to pass different stages before they can offer their products to the public And, in most cases, the negative effects are clearly stated 4.6.7 The current crisis and the macropolicies to deal with The authors provide a thorough analysis of the improvements that should be made trying to avoid a new global crisis, but they are not so explicit when developing policies aimed at solving the ongoing crisis Within their analytical framework, it can be concluded that the policies implemented by industrial countries have been – and, in fact, actually are – wrong, considering their magnitude and the way they have been combined While policymakers rely heavily on monetary policy, fiscal stimulus has not been robust enough due to considerations about public debt sustainability As evidenced today, monetary policy has virtually been left alone to deal with the crisis.4 This new paradigm is probably asking too much from monetary policy Moreover, in a balance sheet recession, monetary policy loses grip and proves largely ineffective for the restoration of growth Fiscal policy causes a mild deterrence of economic contraction caused by private sector deleveraging Thus, additional policy tools are required Income and redistribution policies geared to boost the impact of fiscal and monetary policies Tax rebates for creditors have not had the same compensating effect on aggregate expenditure as income transfers to debtors or financial-constrained agents with higher marginal propensity to consume In addition, redistribution policies could interact with monetary policy, as the authors point out For example, a direct subsidy of interest rate to debtors could be better than supplying banks with cheap funds Policymakers should guarantee income and employment stability in order to remove negative expectations rather than pushing through structural reforms which are, in fact, euphemisms of wage cuts during recession Jorge Carrera 315 Promoting early and voluntary debt restructuring The Japanese experience shows that the process of balance sheet cleaning could take several years and is likely to fuel “fears of debt taking”, which constrains future growth Governments should facilitate debt reliefs in order to accelerate the deleveraging process and encourage the private sector to resume their consumption and investment plans Coordinating international efforts to rotate demand and complement countries’ efforts to deleverage private sector balance sheets This includes changes in relative competitiveness not only among advanced and emerging countries, but also within the EU For some European countries, the euro is comparable to the gold standard (Golden Fetters) in the times of the Great Depression 4.6.8 Distributive impacts of policy choices during a crisis The authors state that the inclusion of distributive considerations in monetary policymaking is a key point which has not been adequately stressed by the literature so far Distributional considerations about fiscal policies during crisis are fairly evident and well understood by the public However, distributional issues concerning money and banking are much more subtle, and not so well understood In addition, it is more difficult in this case to reconcile intervention with social fairness The traditional paradigm of monetary policy suggests explicitly that the best thing that monetary policy can to promote employment, growth and distribution is to sustain a low and stable price level Nevertheless, nominal stability could be fertile ground for financial fragility if it goes along with financial deregulation and liberalization In view of the clear distributive impact of financial rescues and the privileged access to the liquidity window, it is no longer true that monetary and regulatory policies are neutral in terms of inequality The democratic legitimacy of economic policy actions is clearly harmed when there is a widespread feeling that “chopper money” has only been dropped over Wall Street In addition, deregulation policies and a passive attitude toward asset price bubbles tend to produce two additional redistributive outcomes: an increase in the share of aggregate profits coming from the finance industry (financialization) in “normal times”; and a widening of the inequality gap due to bonuses and other compensation practices As economists we are aware of the potential damages arising from breaking nominal contracts, especially those in which the banking sector takes part Nevertheless, we should also take into account the high potential cost of policies that break implicit and explicit social contracts Why we not also consider sudden changes in institutions –such as unemployment benefits or 316 Life After Debt employment stability – as a type of “broken promise”? They have pretty much the same effects in the sense that, in both cases, it is impossible to put in practice intertemporal consumption and investment plans Notes R Koo (2011) “El mundo en una recesión de balances,” Ensayos Económicos 63 (July–September), Banco Central de la República Argentina C Reinhart and J.F Kirkegaard (2012) “Financial Repression: Then and Now,” http:// www.voxeu.org/, March P Krugman (2008) “The International Financial Multiplier,” mimeo For an analytical support of this approach see G Mankiw and M Weinzerl (2011) “An Exploration of Optimal Stabilization Policy,” Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol 42, no 1, pp 209–72 For a critique, see O Blanchard (2011) “2011 In Review: Four Hard Truths,” IMF Direct, December Index Page numbers in italics denote references to chapter notes accordion effect 285–6 adaptive expectations 157 adjustment fatigue 296 adjustment rigidities 48 adverse shocks 7, 50, 73, 205 aggregated bond contracts 208–9 aggregate demand 9, 51–3, 54, 56, 65, 127 adverse shocks 50 expansion of 127, 285 and interest rates 34 lack of 57, 65 management 286–9 no credit market segmentation 286–7 unemployment 288–9 Alejandro, Diaz 13 Argentina 18, 26, 27, 29, 106, 118, 133 bailouts 64 Baring crisis (1890) 88 capital flight 96 current account deficit debt crisis 3, 4, 34, 124, 137–8, 147, 305, 313 debt relief 58, 68, 149, 198 GDP volatility 174 hyperinflation 91, 108 UK trade agreement 102 Arrow–Debreu securities 75, 246 Asian Tigers 94 asset prices 9, 29, 44, 53–4 bubbles 5, 12, 125, 128, 304, 315 volatility 286, 289 austerity see fiscal austerity automatic stabilizers 51, 71, 253, 288 Bagehot Rule 162, 302 Bagehot, Walter 1, 17, 228 bailouts 6, 13, 16, 19, 30, 62, 83, 137–8, 290, 293 Argentina 64 East Asia 64 Greece 64, 168, 215 Baker Plans 104 balance of payments crises 88, 90, 94, 122, 128–30, 138, 201 balance sheets 45, 52, 73, 74, 162, 194, 201, 291 crises 23, 56–7, 309–10 recessions 10, 44–5, 309–10 SPVs 237 Balassa–Samuelson effect Bank Advisory Committees 195–6 banking sector bailouts see bailouts balance sheets see balance sheets credit repayments 118–20 failures 10, 62, 102, 116 recapitalization 34, 57, 64, 72, 243 bankruptcy 9–10, 16, 26, 34, 57, 75 Baring crisis (1890) 88 Basel rules 31, 299, 312 beggar thy neighbor behavior 311 Belgium, Investment Pact effects 159 Belize 217 big events 9–10 blue bonds 238 Bolivia 102 hyperinflation 108 bonds blue bonds 238 Brady bonds 196, 218 conventional 270 output growth effects 267 debt retirement fund 238 defaulting 118–20 elite bonds 238 EU project 153 Eurobonds 28, 66, 238, 243 GDP-linked see GDP-linked bonds vanilla 239, 242, 249 bond contracts aggregated 206–7 standstills 208–9 boom–bust cycles 5, 8, 31, 94–100 triggers 126–7 booms 145–8 bootstrapping 255 Brady bonds 196, 216 317 318 Index Brady Plan (1989) 102, 104–5, 119, 148, 149, 193 Brazil 3, 10, 91, 96, 106 currency crisis 125 debt relief 149 GDP volatility 174 hyperinflation 108 Bretton Woods system 76, 198, 314 bubble economy 293 bubbles 12–13, 71, 72, 125, 127 asset price 5, 12, 125, 128, 304, 315 credit 8, 12, 53, 56, 297, 301, 302 debt dot-com 291 housing 33, 34, 43, 45, 49–50, 52, 63, 73, 126 Bulgaria, debt relief 149 CACs see Collective Action Clauses Calvo diagram 233 Calvo, Guillermo 18 self-fulfilling crisis model 27, 232–5 Cameron, David 76 capital account liberalization 127, 146 Capital Asset Pricing Model (CAPM) 249 capital flight 62, 96 capital inflows 5, 23, 88, 122, 123, 125, 127, 128, 130, 138 capital market liberalization 51, 71, 96 capital movement 96, 127 Cartagena Consensus (1984) 103–4 categorical thinking Chile 6, 106, 118, 124 GDP volatility 174 net capital flows 146 Collective Action Clauses (CACs) 25, 180, 183–5, 193, 196, 206–7, 229, 247 Colombia 105, 106 balance of payments crisis 90 commodity prices 21, 95, 96, 97, 98, 248, 250 constant relative risk aversion function 260 consultative committees 209–10 contagion 2, 125, 128, 134, 174, 198, 204, 310 coordination 310–11 Costa Rica 106 debt relief 149 country risk premium 122, 129, 130, 133, 134 credit bubbles 8, 12, 53, 56, 297, 301, 302 credit default swap (CDS) 13, 26, 198, 204, 209, 229–30 creditors classes 216 committees 209–10 increased number of 182–3 preferred creditor status 195, 199, 201, 202, 214 vultures 186–8 credit repayments 118–20 crises see debt crises crisis behavior 284–6 crisis prevention 12–15, 297–302 macro policies 15–18, 297–8 policy reform 301–2 regulation 298–301 Cuba 102 currency denomination of debts 4–5 current account deficit 5, 8, 23, 122, 123, 125, 128, 129, 130, 146, 281, 305 Cyprus 237 debt 54–6, 82 bubbles consolidation 238 deflation 17 denomination of 4–5 dollar-denominated 4, 249, 305 exchange 237 external 34, 87–9, 94–100, 102–6, 110, 134, 137, 204 inherited 60 junk 236–7 mutualization of 66–7 public 2–3, 18, 122, 129, 131 debt crises 1, 3, 4, 43 accordion effect 285–6 behavior in 284–6 dynamics see dynamics explanation of 80–1 instability 283–4 Latin America 2, 21–3, 24, 87–115 mitigation 56–8 overdeterminacy 283–4 prevention see crisis prevention private sector 3, 18–19, 30, 289–94 prolonged 82–3 resolution 83, 314–15 macro management 15–18 ... RG21 6XS, England Life After Debt The Origins and Resolutions of Debt Crisis Edited by Joseph E Stiglitz University Professor, Columbia University, USA and Daniel Heymann Professor of Economics,... Ministry of the Economy, the Institute for the Integration of Latin America and the Caribbean (INTAL , IDB) and the National University of Córdoba (UNC) The project of the conference derived from the. .. in the midst of an emergency) The history of the last forty years, since the beginning of the liberalization movement in the late 1970s, is the history of one bailout after another; and while the