Presentation at the 2011 Philadelphia Fed Policy Forum December 2, 2011 Enrique G. Mendoza Enrique G. Mendoza University of Maryland & NBER
1. Short: May/Dec. 2010 Greece, Ireland plans 2. Tall: July 2011 Greece plan B w. tiny haircuts 3. Grande: Oct. 2011 European plan (EFSF: leverage and guarantees, 50% haircuts ) 4. Venti: Nov-Dec 2011 European plan B (boost EFSF, create EMF, re-lending via IMF ) 5. With extra shot: Nov. 30, 2011 (coordinated d 50bpts cut in overnight dollar swaps) this may all seem new, but in fact the endgame of financial crisis often features
1) Fiscal solvency math: even governments cannot run Ponzi games 2) Fixed ex. rates and fiscal chaos don t mix 3) Aiming to repay excessive e e debt ratios is not optimal and often not feasible (reforms & austerity alone do not solve debt crises) 4) Sovereign defaults feature deep recessions 5) This time is different syndrome
1) Default by sovereign nations that share a central bank 2) EU-wide financial system vulnerable to default risk of individual sovereigns 3) Three way strategic interaction: a) Individual sovereigns b) Regional (large country) authorities/institutions c) Too big to fail financial intermediaries 4) Developed countries need financing from developing countries!
1. Decoupling & widening of spreads since 07 2. Surge in debt ratios 3. Systemic banking vulnerability to sovereign & broader macro risks 4. Leveraging g of the ECB s balance sheet 5. Defaults & Great Recessions
3000 Greece's Rescue Package II 2500 Ireland's Rescue Package 2000 basis points 1500 1000 Greece's Rescue Package I Lehman's Collapse 500 0 Jan- 00 Aug- 00 Mar- 01 Sep- 01 Apr- 02 Oct- 02 May- 03 Dec- 03 Jun- 04 Jan- 05 Jul- 05 Feb- 06 Aug- 06 Mar- 07 Oct- 07 Apr- 08 Nov- 08 May- 09 Dec- 09 Jun- 10 Jan- 11 Aug- 11-500 Portugal Greece Spain Ireland
500 400 Greece's Rescue Package II Ireland's Rescue Package Greece's Rescue Package I 300 basis points 200 Lehman's Collapse 100 0 Jan- 00 Aug- 00 Mar- 01 Sep- 01 Apr- 02 Oct- 02 May- 03 Dec- 03 Jun- 04 Jan- 05 Jul- 05 Feb- 06 Aug- 06 Mar- 07 Oct- 07 Apr- 08 Nov- 08 May- 09 Dec- 09 Jun- 10 Jan- 11 Aug- 11-100 UK Italy France
1 0.8 06 0.6 0.4 02 0.2 basis points 0 Jun- 01-0.2-0.4-0.6 Jan- 02 Jul- 02 Jan- 03 Jul- 03 Feb- 04 Aug- 04 Feb- 05 Aug- 05 Lehman's Collapse Mar- 06 Sep- 06 Mar- 07 Greece's Rescue Package I Ireland's Rescue Package Greece's Rescue Package II Sep- 07 Apr- 08 Oct- 08 Apr- 09 Oct- 09 May- 10 Nov- 10 May- 11-0.8-1 Portugal Greece Spain Ireland
1 0.8 0.6 basis points 0.4 0.2 Lehman's Collapse Greece's Rescue Package I 0 Jun- Jan- Jul- Jan- Jul- Feb- Aug- Feb- Aug- Mar- Sep- Mar- Sep- Apr- Oct- Apr- Oct- May- Nov- May- 01 02 02 03 03 04 04 05 05 06 06 07 07 08 08 09 09 10 10 11-0.2-0.4 Ireland's Rescue Package Greece's Rescue Package II UK Italy France
160 140 120 100 Debt / GDP 80 60 40 20 0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Portugal Greece Spain Ireland
140 120 100 Debt / GDP 80 60 40 20 0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Italy France United Kingdom Germany
0.25 0.2 0.15 0.1 005 0.05 0 ES:Spain GR:Greece IE:Ireland IT:Italy PT:Portugal PIGS + Italy US Germany France UK (Lendi ng to PIGS + Italy Sovereigns) / Banks' Capita l
1.2 1 0.8 0.6 0.4 0.2 0 ES:Spain GR:Greece IE:Ireland IT:Italy PT:Portugal PIGS + Italy US Germany France UK ( Total Lending to PIGS + Italy )/ Banks' Capital
800% 700% 600% 500% 400% 300% 200% 100% 0% 1998 98W53 1999 99W21 1999 99W42 2000 00W11 2000 00W32 2001 01W01 2001 01W22 2001 01W43 2002 02W12 2002 02W33 2003 03W02 2003 03W23 2003 03W44 2004 04W13 2004 04W34 2005 05W02 2005 05W23 2005 05W44 2006 06W13 2006 06W34 2007 07W03 2007 07W24 2007 07W45 2008 08W14 2008 08W35 2009 09W04 2009 09W25 2009 09W46 2010 10W14 2010 10W35 2011 11W04 2011 11W25 Securities held for monetary policy purposes Other securities General government debt Sum as percent of ECB capital
23 default events in 1977-2009: Argentina 1982Q2 & 2002Q1, Chile 1983Q1, Croatia 1992Q2, Domin. Rep. 1993Q1, Ecuador 1999Q3, Indonesia 1998Q3, Mexico 1982Q4, Moldova 2002Q1, Nigeria 1983Q1 & 1986Q4, Pakistan 1998Q3, Peru 1983Q2, Philippines 1983Q4, Russia 1998Q4, South Africa 1985Q2 & 1993Q1, Thailand 1998Q1, Ukraine 1998Q4, Uruguay 1990Q2 & 2003Q2, Venezuela 1995Q3 & 1998Q3 Event windows for macro variables using HPfiltered quarterly cyclical components Median devs. from trend around defaults: GDP -5%, C -6.5%, L -20%, IntGds -20%, Imp. IntGds -25%, and DNX/GDP/ of 12 ppts.
Debt ratio b t preserves fiscal solvency if: b t =E t [PDV of primary balance t,, ] Bohn (95): a positive response of pb to lagged debt is sufficient: Mendoza & Ostry JME 08 examined evidence using cross section of 22 ICs, 34 EMs ρ=0.04 and significant for countries w. E[b]<62% ρ not significant for countries with E[b]>62% (PIGS and Italy in this group!) Predicted long-run debt averages in 40-60% range
Emergency bailouts via gov./central bank purchases of bank s toxic assets are credible in part because they represent claims on future fiscal revenues (bad debts become national public debts) but there is no European-wide fiscal authority to back up large, systemic bailout (e.g. ECB debt purchases, EFSF) Eurozone considering tighter fiscal union, EMF/ECB large debt purchases from banks
Real choice is orderly v. disorderly crisis Large, credible sov. debt restructuring historically, renegotiations take 3-6 years, with 40% avg. haircut, but debt 15ppts higher Large liquidity injections to banks If Euro persists, will need credible commitment of future Euro-wide tax revenues and reforms (EMF) If Euro abandoned, d countries can follow usual strategies individually Option to globalize the costs using IMF p g g Risk of sharp macro downturn