International Debt Deleveraging Luca Fornaro London School of Economics ECB-Bank of Canada joint workshop on Exchange Rates Frankfurt, June 213 1
Motivating facts: Household debt/gdp Household debt/gdp (percent) 4 6 8 1 12 1999 21 23 25 27 29 211 Ireland Un. Kingdom Portugal United States Spain 2
Motivating facts: Current account/gdp Current account/gdp (percent) -6-4 -2 2 4 Euro core Japan United Kingdom United States Euro periphery 1999 21 23 25 27 29 211 3
Motivating facts: GDP Real GDP (index, 27=1) 92 94 96 98 1 12 United States Euro core Japan United Kingdom Euro periphery 27 28 29 21 211 212 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 (24), Christiano, Gust and Roldos (24), Gertler, Gilchrist and Natalucci (27), Schmitt-Grohe and Uribe (211) Deleveraging and liquidity traps: Eggertsson and Krugman (21), Guerrieri and Lorenzoni (21), Benigno and Romei (212) 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 1
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 Budget constraint E [ t= C T i,t + p N i,tc N i,t + B i,t+1 R t Borrowing constraint β t U ( C T i,t, C N i,t, L i,t ) ] B i,t+1 κ = w i,t L i,t + B i,t + Π i,t Optimality conditions 13
Firms Tradable sector ( ) Yi,t T = A T i,t L T αt i,t A T i,t is a country-specific productivity shock Non-tradable sector Yi,t N = A ( ) N L N αn i,t 14
Market clearing Tradable consumption good Ci,t T = Yi,t T B i,t+1 + B i,t R t Non-tradable consumption good Labor World market clearing 1 C T i,t di = Ci,t N = Yi,t N L i,t = L T i,t + L N i,t 1 Y T i,t di 1 B i,t+1 di = 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 ( NFA i,t NFA i,t 1 = CA i,t = Yi,t C T i,t+b T i,t 1 1 ) R t 1 16
Functional forms Preferences U ( C T, C N, L ) = C 1 γ 1 γ L1+ψ 1 + ψ Productivity shock C = ( C T ) ω ( C N ) 1 ω A T i,t = ρa T i,t 1 + ɛ i,t 17
Parameters Table 1: Parameters (annual) Value Source/Target Risk aversion γ = 4 Standard value Discount factor β =.9756 R = 1.25 Frisch elasticity of labor supply 1/ψ = 1 Kimball and Shapiro (28) Labor share in trad. sector α T =.65 Standard value Labor share in non-trad. sector α N =.65 Standard value Share of trad. in consumption ω =.5 Stockman and Tesar (1995) TFP process σ ɛ =.194 Benigno and Thoenissen (28) ρ =.84 Initial borrowing limit κ =.9 Debt/GDP= 2% 18
Policy functions.4 Current account 1.31 1.3 Labor High TFP Low TFP.2 1.29 1.28 1.27.2 1.26 1.25.9.8.7.6.5.9.8.7.6.5 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.8.6 Fraction.4.2 1 5 5 1 15 2 25 3 Net foreign assets/gdp 2
Deleveraging shock Start from steady state with κ = κ H Unexpected permanent drop to κ = κ L < κ H I set κ L =.75κ 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.9 Borrowing limit 21 World debt/gdp.8.7 percent 2 19.6 1 1 2 3 4 percent 3 2 1 Interest rate 1 1 2 3 4 years % dev. from initial ss 18 1 1 2 3 4.2.15.1.5 World output.5 1 1 2 3 4 years Tradable good Non-tradable good 23
Impact response across the NFA distribution change from initial steady state 15 1 5 5 Current account/gdp 2th p er c. 5t h p er c. % deviation from initial ss 15 1 5 Output of tradables 2t h p er c. 5t h p er c. B < k 1 1.5.5 1 5 1.5.5 1 Wealth at the start of the transition : B Wealth at the start of the transition : B % deviation from initial ss 5 5 Consumption of tradables 2th p er c. 5t h p er c. % deviation from initial ss 5 5 2t h p er c. Real wage 5t h p er c. 1 1.5.5 1 Wealth at the start of the transition : B 1 1.5.5 1 Wealth at the start of the transition : B Current account equation 24
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 P T t C T i,t + P N i,tc N i,t + B i,t+1 R N t = W i,t L i,t + B i,t + Π i,t Bonds are denominated in units of currency Borrowing limit B i,t+1 P T t+1 κ 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 ) From period t = 1 wages are fully flexible 29
Transitional dynamics in a monetary union.9 Borrowing limit 21 2 World debt/gdp.8 percent 19.7 18 percent.6 1 1 2 3 4 4 2 2 Interest rate 4 Monetary union Flex. wage 6 1 1 2 3 4 years % dev. from initial ss 17 1 1 2 3 4.1.1 World output Tradable good Non-tradable good.2 1 1 2 3 4 years 3
Impact response across the NFA distribution change from initial steady state 15 1 5 5 Current account/gdp 2th p er c. 5t h p er c. % deviation from initial ss 15 1 5 Output of tradables 2t h p er c. 5t h p er c. B < k 1 1.5.5 1 5 1.5.5 1 Wealth at the start of the transition : B Wealth at the start of the transition : B % deviation from initial ss 5 5 1 15 2 25 Consumption of tradables 2th p er c. 5t h p er c. % deviation from initial ss 5 5 1 15 Output of non-tradables 2t h p er c. 5t h p er c. 3 1.5.5 1 Wealth at the start of the transition : B 2 1.5.5 1 Wealth at the start of the transition : B Production of non-tradables 31
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 ˆR t N as the nominal interest rate consistent with the inflation target Now monetary policy is given by R N t = MAX ( ) ˆRN t, 1 During period, 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
Transitional dynamics in a liquidity trap.9 Borrowing limit 21 World debt/gdp.8.7 percent 2 19 percent.6 1 1 2 3 4 3 2 1 Interest rate 1 1 1 2 3 4 years % dev. from initial ss 18 1 1 2 3 4 1 1 World output 2 Tradable good Non-tradable good 3 1 1 2 3 4 years 34
Impact response across the NFA distribution change from initial steady state 2 15 1 5 5 Current account/gdp 2th p er c. 5t h p er c. % deviation from initial ss 1 5 5 Output of tradables 2t h p er c. 5t h p er c. B < k % deviation from initial ss 1 1.5.5 1 5 5 1 15 2 25 3 35 Wealth at the start of the transition : B Consumption of tradables 2th p er c. 5t h p er c. 4 1.5.5 1 Wealth at the start of the transition : B % deviation from initial ss 1 1.5.5 1 5 5 1 15 2 25 Wealth at the start of the transition : B Output of non-tradables 2t h p er c. 5t h p er c. 3 1.5.5 1 Wealth at the start of the transition : B 35
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 36
Policy experiments One period is a quarter Persistent nominal wage rigidities Gradual tightening of the borrowing limit 37
Transitional dynamics index (t 1 =1) 3.2 3 2.8 2.6 2.4 12 1 98 96 94 92 Borrowing limit 1 1 2 3 4 5 6 7 8 9 1 11 12 13 Consumer price index 9 1 1 2 3 4 5 6 7 8 9 1 11 12 13 quarters percent percent (annualized) 88 86 84 82 8 World debt/gdp 78 1 1 2 3 4 5 6 7 8 9 1 11 12 13 2 15 1 5 Real interest rate 1 1 2 3 4 5 6 7 8 9 1 11 12 13 quarters percent (annualized) % deviation from initial ss 2 15 1 5 2 4 Nominal interest rate 1 1 2 3 4 5 6 7 8 9 1 11 12 13 2 World output 6 Trad. Non-trad. 8 1 1 2 3 4 5 6 7 8 9 1 11 12 13 quarters 38
Changing the inflation target percent percent (annualized) 9 88 86 84 82 8 78 2 15 1 World debt/gdp 1 1 2 3 4 5 6 7 8 9 1 11 12 13 5 Real interest rate 5 1 1 2 3 4 5 6 7 8 9 1 11 12 13 quarters percent (annualized) % deviation from initial ss 2 15 1 5 Nominal interest rate 5 1 1 2 3 4 5 6 7 8 9 1 11 12 13 2 4 6 World output - tradables 2 8 1 1 2 3 4 5 6 7 8 9 1 11 12 13 quarters index (t 1 =1) % deviation from initial ss 11 15 1 95 Consumer price index 9 1 1 2 3 4 5 6 7 8 9 1 11 12 13 2 2 4 World output - non-trad. 6 inf. target = 2% inf. target = 4% 8 1 1 2 3 4 5 6 7 8 9 1 11 12 13 quarters 39
Soft landing index (t 1 =1) 3.2 3 2.8 2.6 2.4 15 1 95 Borrowing limit 1 1 2 3 4 5 6 7 8 9 1 11 12 13 Consumer price index 9 1 1 2 3 4 5 6 7 8 9 1 11 12 13 quarters percent % deviation from initial ss 9 85 8 75 World debt/gdp 7 1 1 2 3 4 5 6 7 8 9 1 11 12 13 2 4 6 World output - tradables 2 8 1 1 2 3 4 5 6 7 8 9 1 11 12 13 quarters percent (annualized) % deviation from initial ss 2 15 1 5 Nominal interest rate 5 1 1 2 3 4 5 6 7 8 9 1 11 12 13 2 2 4 World output - non-trad. 6 baseline soft landing 8 1 1 2 3 4 5 6 7 8 9 1 11 12 13 quarters 4
Conclusion Main message: monetary unions are particularly prone to enter a liquidity trap during deleveraging Other policy tools Fiscal transfers and debt relief policies (Fornaro 213) 41
Thank you 42
Household s optimality conditions p N i,t = U C N i,t U C T i,t U Li,t = w i,t U C T i,t U C T i,t R t = βe t [ U C T i,t+1 ] + µ i,t B i,t+1 κ, with equality if µ i,t >, Back 43
Nominal wage rigidities and the exchange rate Define S i as country i nominal exchange rate against the key international currency P T i,t = S i,t P T t Normalize P T = 1, firms labor demand implies ( L T i,t = α T A T i,t S i,t W i,t ) 1 1 α T Back 44
The current account Back ( CA i,t = Yi,t T Ci,t T + B i,t 1 1 ) R t 1 45
Real exchange rate and production of non-tradables Real exchange rate P N i,t = 1 ω ω Ci,t T P T Ci,t N t Equilibrium labor in the non-tradable sector L N i,t = ( α N A P N ) 1 N 1 α N i,t W i,t Back 46
Motivating facts: Household debt/gdp Household debt/gdp (percent) 4 6 8 1 12 1999 21 23 25 27 29 211 Ireland Un. Kingdom Portugal United States Spain 47
Motivating facts: Current account/gdp Current account/gdp (percent) -6-4 -2 2 4 Euro core Japan United Kingdom United States Euro periphery 1999 21 23 25 27 29 211 48
Motivating facts: CA deficits and unemployment Current account/gdp in 27-15 -1-5 5 1 DEU NLD JPN FIN AUT BEL FRA ITA GBR USA PRT IRL GRC -5 5 1 15 Change in unemployment rate - 27/211 ESP 49
Eurozone: net debtors NFA/GDP Eurozone - net debtors NFA/GDP percent -2-15 -1-5 198 199 2 21 year Source: data from Milesi-Ferretti and Lane (29) Back 5
A model with interest rate spreads Suppose households in country i are charged the interest rate R i,t U C T i,t ] = R i,t βe t [U C T i,t+1 Assuming the borrowing constraint in the main text R [ ] t U C T i,t = 1 µ i,t R t βe t U C T i,t+1 U C T i,t The two models are isomorphic if R i,t = R t 1 µ i,t R t U C T i,t and if the spread R i,t R t is rebated to households in country i through lump-sum transfers 51