IMPLICATIONS OF LOW PRODUCTIVITY GROWTH FOR DEBT SUSTAINABILITY Neil R. Mehrotra Brown University Peterson Institute for International Economics November 9th, 2017 1 / 13
PUBLIC DEBT AND PRODUCTIVITY GROWTH OECD ECONOMIES Japan Italy Portugal Belgium United Kingdom Spain France United States Austria Ireland Netherlands Finland New Zealand Canada Germany Australia Sweden Denmark Korea Switzerland Debt to GDP 2015 2000 0 50 100 150 200 Ireland Korea Australia Sweden Japan Denmark Spain Germany Canada France Portugal Austria Netherlands Finland Switzerland United States Belgium New Zealand United Kingdom Italy Labor productivity growth 2010-2016 1990-1999 0.00 1.00 2.00 3.00 4.00 5.00 2 / 13
DEBT SERVICING COSTS OECD ECONOMIES Portugal Italy Spain Slovenia Hungary Poland Finland New Zealand France Mexico Switzerland Chile Luxembourg Denmark Israel Korea Australia Sweden Czech Republic Slovak Republic Netherlands Iceland Germany Canada Latvia Belgium Norway Austria United States United Kingdom Japan Ireland Unit fiscal cost: r - g -4.0-2.0 0.0 2.0 4.0 Portugal Italy Spain Slovenia Hungary Poland Finland New Zealand France Mexico Switzerland Chile Luxembourg Denmark Israel Korea Australia Sweden Czech Republic Slovak Republic Netherlands Iceland Germany Canada Latvia Belgium Norway Austria United States United Kingdom Japan Ireland Debt servicing cost -4.00-2.00 0.00 2.00 4.00 US fiscal cost 3 / 13
RESEARCH QUESTION AND APPROACH: Key tradeoff: Persistent r < g implies the increases in debt raise revenues With a large stock of public debt, interest rate reversals impose sizable fiscal costs Approach: Empirical evidence on level and variability of debt servicing costs Interest rate and debt servicing cost projections for the G7 Employ a quantitative model to study implications for debt servicing cost of low productivity growth 4 / 13
Median 0.13-0.35-0.52-0.37 75th percentile 2.82 1.85 1.99 1.26 HISTORICAL DEBT SERVICING COST Fraction < 0 48.8% 55.3% 56.5% 59.7% Fraction < -2% 29.7% 31.7% 34.4% 32.8% Servicing the public debt: No. of observations 2107 1068 131 67 Real interest rate is the long-term nominal interest rate less a three-year moving average of inflation rates. Fraction < 0 is the percentage of years with T t + B g negative t+1 = G net fiscal cost. Fraction t + (1 + r t ) B g < -2% is the percentage of years with net fiscal cost of less than -2%. Statistics based on data set after observations with net fiscal t cost > 10% or less than -10% are dropped. T = G + (r g) B g Using five-year averages - winsorized at +- 10% 17 Advanced Countries United States 1870-2013 1946-2013 1870-2013 1946-2013 Net fiscal cost: r - (g+n) 25th percentile -2.64-2.74-2.15-1.72 Median 0.08-0.38-0.16-1.35 75th percentile 2.28 1.55 1.09 0.57 Fraction < 0 49.3% 54.3% 55.2% 69.2% Fraction < -2% 31.4% 32.6% 31.0% 23.1% No. of observations 493 221 29 13 Real interest rate is the long-term nominal interest rate less a three-year moving average of inflation rates. Fraction < 0 is the percentage of years with negative net fiscal cost. Fraction < -2% is the percentage of years with net fiscal cost of less than -2%. Statistics based on data set after observations with net fiscal cost > 10% or less than -10% are winsorized at thresholds. 5 / 13
DEBT SERVICING COST AND PRODUCTIVITY GROWTH ADVANCED ECONOMIES: 1870-2013 -.1 -.05 0.05.1 -.2 -.1 0.1.2 Real GDP per capita growth (5-year averages) Fiscal cost (5-year averages) Fitted values 6 / 13
REVERSION SCENARIOS CURRENT G7 COVARIATES Probit specification: P ( fisc i,t+j > 0 X ) = Φ ( c + β f fisc i,t + β p popgrwth i,t + β d dgdp i,t + ɛ i,t ) Reversion Scenarios Countries Likelihood of r > g 5-year forward 10-year forward Debt to GDP ratio Fiscal consolidation Current unit cost Current fiscal cost Fiscal cost if r-g = 1.55% Canada 41.2% 47.9% 67-1.54% -1.03 1.01 France 52.8% 54.8% 96-0.14% -0.14 1.44 Germany 49.0% 57.3% 68-1.62% -1.10 1.02 Italy 83.5% 71.7% 133 2.43% 3.23 2.00 Japan 24.9% 38.1% 198-1.51% -2.98 2.97 United Kingdom 38.2% 48.1% 90-1.84% -1.65 1.35 United States 41.1% 47.9% 76-1.42% -1.08 1.14 Reversion probabilities obtained as fitted values from regression specifications (2) - (3), and (5) - (6) with r - g - n = 0.0054, g = 0.007, n = 0.007, and debt to GDP ratio of 0.7. Optimistic and pessimistic scenarios consider alternatives with g = 0.015 and g = 0 respectively. Fiscal cost (% of GDP) is r - g - n multiplied by debt to GDP ratio of 70%. Probit estimates 7 / 13
DEBT SERVICING COST PROJECTIONS Scenario Summary Countries Canada France Germany Japan Italy UK USA Real interest rates Current: 2012-2017 0.41 0.70-0.25-0.28 2.10 0.26 0.74 Projection: 2018-2025 1.38 1.76-0.25-1.01 1.13 1.71 1.00 GDP per capita growth Current: 2012-2017 0.95 0.27 1.34 1.21-0.49 1.62 1.30 Downside (PIIE estimates) 0.70 0.50 0.50 0.10 0.10 0.50 0.70 Cost of servicing the debt (% of GDP) Current: 2012-2017 -1.00-0.10-1.12-2.93 3.19-1.66-1.08 Projection: 2018-2025 -0.35 0.92-1.12-4.38 1.90-0.35-0.88 Downside (PIIE estimates) -0.18 0.70-0.55-2.18 1.12 0.66-0.43 Real interest rates are averages from 2012-2017 of nominal rates on 10-year government debt less the average inflation rate as measured by a consumer price index (data from OECD). Interest rate projection are obtained from the bilateral VECM model for the G6 and 2-variable VECM for the US. GDP per capita growth rates and population growth are 5-year averages from the OECD and Jorda, Real Schularick interest and Taylor databases raterespectively. projections The debt to obtained GDP ratio is obtained from national 3-variable sources. The unit VECM cost of servicing the debt is simply r - g where g is the sum of population growth and GDP per capita growth. The fiscal cost of servicing the debt is the unit cost multiplied by the stock of debt. Uncertainty bands quite large for real interest rate projections VECM estimates 8 / 13
INTEREST RATE DETERMINATION IN A LIFECYCLE MODEL Debt servicing cost: (( 1 + r ( g, n, B g )) (1 + g) (1 + n) ) B g Quantitative 56-period lifecycle model Households face lifecycle profile of income, save for retirement, and face mortality risk Calibrate to US labor share, I/Y, real interest rate r, risk premia 9 / 13
EFFECT OF PRODUCTIVITY GROWTH ON US FISCAL COST MODEL INTEREST RATE ELASTICITIES 2.0% 1.5% Real Interest Rate 1.0% 0.5% IES = 0.5 IES = 1 IES = 2 45 degree line 0.0% 0.0% 0.5% 1.0% 1.5% 2.0% Productivity Growth 10 / 13
EFFECT OF DEBT TO GDP RATIO ON US FISCAL COST 20.0% 19.8% 19.6% Taxes (% of GDP) 19.4% 19.2% 19.0% 18.8% 18.6% 18.4% 18.2% 18.0% 0.4 0.6 0.8 1 1.2 Debt to GDP Ratio 11 / 13
DEBT SUSTAINABILITY IN SMALL OPEN Debt servicing cost: ECONOMIES ((1 + r (g, n )) (1 + g) (1 + n)) B g Evidence of a stronger common component in rates than growth Key determinant: deviation of g from global prod. growth g Indirect channels: real exchange rate and financial stability Evidence that when US real rates are low, RER appreciates, loan growth increases, house prices increase Int l spillovers 12 / 13
Lessons: KEY TAKEAWAYS On average, cost of servicing the debt is frequently negative Nevertheless, servicing cost shows substantial variability and a moderate likelihood of reversion in medium term Slower productivity growth may benefit debt sustainability by lowering real interest rate Even with r < g, revenue-maximizing level of debt is lower Limitations: r g not a sufficient statistic for optimal level of debt Abstracted from any constraints on real rates due to the ZLB 13 / 13
Additional Slides 14 / 13
COST OF SERVICING THE US PUBLIC DEBT 30% 20% 10% 0% -10% -20% Fiscal cost: r-g-n Fiscal cost, 5-yr MA -30% 1872 1882 1892 1902 1912 1922 1932 1942 1952 1962 1972 1982 1992 2002 2012 Back 15 / 13
REVERSION LIKELIHOODS Probit specification: ( P ) fisc i,t+j > 0 X Probit Regressions Using five-year averages - winsorized at +- 10% ) = Φ (c + β f fisc i,t + β p popgrwth i,t + β d dgdp i,t + ɛ i,t 5-year forward: (r > g+n) 10-year forward (r > g+n) Variable (2) (3) (5) (6) Current value: r - (g+n) 12.483*** 25.869*** 5.707*** 12.895*** (1.174) (3.430) (1.421) (3.281) Debt to GDP ratio -0.146-0.142-0.212-0.204 (0.183) (0.280) (0.189) (0.315) Population growth -29.185** -24.618-24.450** -28.148 (11.762) (23.497) (10.973) (22.866) Constant 0.363** 0.373* 0.300** 0.483** (0.145) (0.200) (0.143) (0.207) McFadden pseudo R-squared 0.120 0.260 0.037 0.110 No. of observations 448 204 431 187 The dependent variable is a dummy variable that takes a value of 1 if the fiscal cost measure is positive (i.e. r > g+n) in next period (1-5 years forward) and in the subsequent period (6-10 years forward) respectively. Columns (1) and (4) do not include population growth; columns (3) and (6) limit the sample to the postwar period. Each column presents a separate regression. Standard errors are clustered at the country level. *** are coefficients significant at the 1% level, ** are coefficients significant at the 5% level, and * are coefficients Back 16 / 13
EXTERNAL AND FINANCIAL SPILLOVERS TO SMALL OPEN ECONOMIES Fixed effects specification: y i,t = c i + δ1 t + δ lag 1 t 1 + ɛ i,t Fixed Effect Regressions External Real exchange rate Financial Mortgage loan growth Dependent variable Current account Loan growth House prices (1) (2) (3) (4) (5) US real rate (< 1%) 0.000-0.033*** 0.007 0.004 0.009 (0.003) (0.004) (0.006) (0.008) (0.006) US real rate (< 1%, 5 yr. lag) -0.012** 0.023*** 0.031*** 0.030*** 0.021* (0.005) (0.005) (0.007) (0.008) (0.010) H0: Sum of current and one lag -0.012* -0.010* 0.038*** 0.034*** 0.030** (0.006) (0.005) (0.008) (0.010) (0.012) Country fixed effects Yes Yes Yes Yes Yes No. of observations 208 208 208 208 190 The dependent variable is described in the first row, the independent variable is a dummy variable that is equal to 1 when US real interest rates are below 1%. Each column presents a separate regression. Standard errors are clustered at the country level. *** are coefficients significant at the 1% level, ** are coefficients significant at the 5% level, and * are coefficients significant at the 10% level. Back 17 / 13
COMMON COMPONENT IN RATES AND GDP GROWTH 15.0% 15.0% 10.0% 10.0% 5.0% 5.0% 0.0% -5.0% 0.0% -10.0% -5.0% -15.0% 1950 1960 1970 1980 1990 2000 2010-10.0% 1950 1960 1970 1980 1990 2000 2010 18 / 13
VECM specification: VECM Estimates VECM ESTIMATES OF REAL RATES J y t = γ + αβy t 1 + Π j y t j + ɛ t j=1 Countries Canada France Germany Japan Italy UK USA Cointegration coefficients US real interest rate -0.96** -0.83** -0.76** -1.40** -1.58** -1.45** N/A (0.12) (0.14) (0.13) (0.28) (0.27) (0.35) N/A Local GDP per capita growth 0.82** 0.01-0.65** -0.06 0.26 2.62** -4.50** (0.13) (0.16) (0.11) (0.15) (0.23) (0.44) (0.89) Error-correction coefficients Local real interest rate -0.22** -0.44** -0.11-0.06-0.21** -0.07** N/A (0.07) (0.09) (0.08) (0.08) (0.07) (0.02) N/A US real interest rate -0.10-0.005 0.19** 0.19** 0.08-0.04 0.01 (0.08) (0.08) (0.09) (0.05) (0.06) (0.03) (0.02) Johansen trace statistic H0: No cointegrating relationship 65.93** 44.48** 40.98** 33.26* 27.81 63.40** 28.96** Lag specification Criterion AIC AIC AIC AIC AIC AIC AIC Lag length 2 2 2 2 4 2 3 No. of observations 64 64 64 64 62 64 63 Each column presents a separate estimation of a vector error correction model assuming 1 cointegration vector and consisting of the local long-term real interest rate, the long-term US real interest rate, and local GDP per capita growth. Data are from 1950-2015 and presents cointegration coefficients and error correction coefficients for local and US rates (error-correction term for GDP per capita and lag coefficients are suppressed). Estimates via maximum likelihood and Johansen trace statistic critical values are 29.68 and 35.65 at the 5% and 1% levels. ** are coefficients significant at the 1% level, and * are coefficients significant at the 5% level. 19 / 13
REAL INTEREST RATE PROJECTIONS: US AND UK 10.00 8.00 6.00 4.00 Real interest rate VECM forecast VECM (4 country) 7.00 6.00 5.00 4.00 3.00 2.00 0.00-2.00 2.00 1.00 0.00-1.00 Real interest rate VECM forecast VECM (4 country) -4.00 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025-2.00 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 20 / 13
REAL INTEREST RATE PROJECTIONS: JAPAN AND GERMANY 6.00 7.00 4.00 Real interest rate VECM forecast VECM (4 country) 6.00 5.00 Real interest rate VECM forecast VECM (4 country) 2.00 4.00 3.00 0.00 2.00 1.00-2.00 0.00-4.00-1.00-2.00-6.00 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025-3.00 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 21 / 13
REAL INTEREST RATE PROJECTIONS: FRANCE AND ITALY 8.00 7.00 6.00 Real interest rate VECM forecast 10.00 8.00 Real interest rate VECM forecast 5.00 6.00 4.00 3.00 4.00 2.00 1.00 2.00 0.00 0.00-1.00-2.00-2.00-3.00 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025-4.00 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 Back 22 / 13