Author: John McHale

The Royal Irish Academy Social Sciences Committee in association with the UCD College of Social  Sciences and Law will be holding a conference on the topic Debating Austerity on October 29-30.  The Keynote Lecture and conference will be held at the RIA building at 19 Dawson Street, Dublin 2.

The Keynote Lecture will be given by Professor Simon Wren-Lewis of Oxford University at 6pm, Thursday October 29 (lecture details below).  The lecture will be chaired by Patrick Honohan, Governor, Central Bank of Ireland.

This will be followed on Friday, October 30 by a full day of sessions debating the experience of austerity in Ireland from a variety of perspectives.

Further information on the conference and registration details are available here.   The admission price for the Keynote Lecture on Thursday evening is €5; admission to Friday’s conference is free.

Keynote Lecture: How to Avoid Austerity

Abstract:

Austerity may be defined as a large fiscal contraction that causes a substantial increase in unemployment. If the government has a budget deficit that is unsustainable, or a debt level that is too high, it is sometimes suggested that austerity is inevitable. For an economy with a flexible exchange rate and debt in its own currency, which includes the Eurozone as a whole, this is simply false. Fiscal contraction can always be delayed until monetary policy can offset the deflationary impact of any fiscal contraction. Unfortunately this is not true for a member of a currency union that requires a greater fiscal contraction than the union as a whole. Even in this case, however, a sharp and deep fiscal contraction will be an inefficient waste of resources. As the macroeconomic theory behind these propositions is simple and widely accepted, the interesting question about the current global austerity is why it has happened.

Simon Wren-Lewis is currently Professor of Economic Policy at the Blavatnik School of Government at Oxford University, having previously been a professor in the Economics Department at Oxford.   He is also an Emeritus Fellow of Merton College.   In September 2015 he was appointed to the British Labour Party’s Economic Advisory Committee.

Paul Krugman has provided a new paper and post on the effects of a “sudden stop” of capital inflows in a country with a floating exchange rate and constrained by the zero lower bound on the short-term interest rate.  In previous posts (see here and here), Paul made two claims: (i) that a government operating an independent monetary policy should be able prevent a loss of creditworthiness; and (ii) that even if that loss did occur its effect would be expansionary through a depreciation of the exchange rate. 

He sets out the two issues in the introduction to the new paper:

What I want to talk about instead is a question that some of us have been asking with growing frequency over the last couple of years: Are Greek-type crises likely or even possible for countries that, unlike Greece and other European debtors, retain their own currencies, borrow in those currencies, and let their exchange rates float? 

What I will argue is that the answer is “no” – in fact, no on two levels. First, countries that retain their own currencies are less vulnerable to sudden losses of confidence than members of a monetary union – a point effectively made by Paul De Grauwe (2011). Beyond that, however, even if a sudden loss of confidence does take place, countries that have their own currencies and borrow in those currencies are simply not vulnerable to the kind of crisis so widely envisaged. Remarkably, nobody seems to have laid out exactly how a Greek-style crisis is supposed to happen in a country like Britain, the United States, or Japan – and I don’t believe that there is any plausible mechanism for such a crisis.

I think a lot of people, for differing reasons, found the second claim too good to be true (although I don’t think anyone has in mind quite a Greek-style crisis).  In a couple of earlier posts (here and here) I suggested one contractionary force: a loss of government creditworthiness could impair balance sheets in the banking system.  

In the new paper, which contains some really nice new modelling, Paul attempts to dispose of various objections to the claim that a creditworthiness shock would be expansionary.   (And for the record I am a big Krugman fan.) Here is what writes on the banking channel:

Several commentators – for example, Rogoff (2013) — have suggested that a sudden stop of capital inflows provoked by concerns over sovereign debt would inevitably lead to a banking crisis, and that this crisis would dominate any positive effects from currency depreciation. If correct, this would certainly undermine the optimism I have expressed about how such a scenario would play out.

The question we need to ask here is why, exactly, we should believe that a sudden stop leads to a banking crisis. The argument seems to be that banks would take large losses on their holdings of government bonds. But why, exactly? A country that borrows in its own currency can’t be forced into default, and we’ve just seen that it can’t even be forced to raise interest rates. So there is no reason the domestic-currency value of the country’s bonds should plunge.

But this response essentially just invokes point (i) – that the government with an independent monetary policy won’t lose creditworthiness.   As far as I can see, it does not deal with the second part of claim that the loss of creditworthiness would actually be expansionary even with adverse effects on the financial system at all.   The problem actually comes out more clearly in the original formulation of Paul’s model, where it is explicitly assumed there is a rise in the risk premium – and presumably a reduction in the market value of outstanding government bonds – and it is shown that the effect is expansionary.  

It still seems to me that to dispense with the banking-related objection Paul needs to argue either theoretically or empirically that this particular contractionary force is not relevant.   On the empirical side, the interesting case studies that he looks at do not isolate an answer to the second claim.  

Finally, it is worth considering a simple thought experiment.   Imagine that in the recent imbroglio over the debt ceiling, a solution wasn’t reached and the US government was forced to (temporarily?) default on its debt.   Thinking back to the post-Lehman experience, I don’t think it is hard to imagine that this would be extremely disruptive to the US financial system, notwithstanding a depreciation of the dollar, in ways that would be difficult for the Fed to fully counter in both the banking and shadow-banking systems. 

Simon has an interesting post on the EU measurement of output gaps and structural budget balances.   See: here.

Philip’s posting last week of the new report from the Committee on International Economic Policy and Reform, Revisiting Sovereign Bankruptcy, attracted little comment.   This is a pity as it is an impressive piece of work – clear and well argued.   The focus of the report:

This year’s CIEPR report argues that both the nature and our understanding of sovereign debt problems have changed in ways that create a much stronger case for an orderly sovereign bankruptcy regime today than ten years ago. 

Some belated and slightly wonkish comments after the break.  Continue reading “Revisiting Sovereign Bankruptcy”

Just a quick follow up to my post questioning the result in Paul Krugman’s model that a sovereign creditworthiness shock is necessarily expansionary in an economy with an independent monetary policy and flexible exchange rates.   I was a little surprised by the ease at which some commentators suggested that questioning this result is absurd.   My suggested extension to Paul’s model is really just the addition of a “balance sheet channel,” but where the balance sheets in question are those of the banks.  The argument for such a channel has been best made by Ben Bernanke.   See, for example, this speech.   An extract:

[T]he cost and availability of nondeposit funds for any given bank will depend on the perceived creditworthiness of the institution.  Thus, the concerns of holders of uninsured bank liabilities about bank credit quality generate an external finance premium for banks that is similar to that faced by other borrowers.  The external finance premium paid by banks is presumably reflected in turn in the cost and availability of funds to bank-dependent borrowers.  Importantly, this way of casting the bank-lending channel unifies the financial accelerator and credit channel concepts, as the central mechanism of both is seen to be the external finance premium and its relationship to borrowers’ balance sheets.  The only difference is that the financial accelerator focuses on the ultimate borrowers–firms and households– whereas financial intermediaries are the relevant borrowers in the theory of the credit channel.

The question then is how a sovereign creditworthiness shock could affect the perceived creditworthiness of domestic banks.   I focused in the previous post on the potential role of the sovereign as a capital backstop for the banks.  But other channels are also potentially present.  The credibility of liability guarantees will depend on the creditworthiness of the sovereign.   Also, to the extent that the banks are holding government bonds, capital losses will erode the banks’ capital. 

There is the question as to whether conventional or unconventional policy could offset contractionary effects of a sovereign creditworthiness shock.   Vasco Cúrdia Michael Woodford, for example, have examined how monetary policy rules should be altered where “financial frictions” are present, though their focus is on borrower rather than bank balance sheets (see here).   But the zero lower bound will presumably limit what even an extended monetary policy rule can achieve.  Maybe QE could help offset the contractionary effects of the induced shocks to bank balance sheets.  (This is separate from the potential role of QE in avoiding the shock to sovereign creditworthiness in the first place.)   But Paul himself has questioned the potency of QE as a stimulus tool.

Update:  Krugman responds to Rogoff’s response here.   (I am spending too much time on this, but it is fascinating.)

I just want to pick up on one point.   Paul asks:

On the economic question at hand, Rogoff seems to be playing bait and switch. Wren-Lewis and I both asked why, exactly, a country like Britain should fear a Greek-style loss of confidence. Rogoff, however, spends most of his piece arguing that Britain would, in fact, be hurt by a euro collapse. Of course it would. So? This doesn’t even seem relevant to Rogoff’s own argument for austerity policies: British austerity might be “insurance” against loss of confidence, but it makes no difference either way to the probability of disaster in Europe. What’s going on here?

Both Paul and Ken agree that a euro collapse would be directly bad for the UK economy.   They clearly disagree on the likely implications for UK creditworthiness.   But there is a further disagreement related to the post above.   If it did occur, Paul believes that the creditworthiness shock would itself be expansionary, and so help offset the direct contractionary impulse of the euro zone shock.   I think Ken believes it would be compounding.   The differences here can affect the perceived value of “insurance.”

 

 

An interesting debate has been taking place following Ken Rogoff’s recent FT piece on the risks of UK sovereign default.   [Update: Rogoff responds to Krugman here.] Simon Wren-Lewis has argued that the risk is overblown given that the UK has can conduct an independent monetary policy (see here).   In extremis, the Bank of England could simply print money to cover debts as they come due.   Also, QE could be used to lower the cost of funding to the government.   (See also the argument of Giancarlo Corsetti and Luca Dedola how co-ordination between the central bank and the treasury could ensure the creditworthiness of the government even without the need for the central bank to act as an unlimited lender of last resort.) 

A more provocative response to Rogoff comes from Paul Krugman.   Using a stripped down New Keynesian open economy model (pdf) he argues that the government’s loss of creditworthiness could actually be expansionary in a liquidity trap.   I hasten to add that this analysis is not meant to apply to a country like Ireland, but only a country with its own independent monetary policy and a flexible exchange rate.  

On the face of it, this looks too good to be true.   But in the topsy-turvey world of the liquidity trap strange things do seem to happen.    In this case, though, I do think it is too good to be true. 

The key to the expansionary result in Paul’s model is what happens to the exchange rate.   Using a standard interest rate parity condition with a risk premium, an increase in the premium leads to a downward jump in the exchange rate.   (Essentially, the exchange rate must fall sufficiently to create expectations of future appreciation that are sufficient to maintain the interest rate parity condition.)   With nominal rigidities, the nominal exchange rate depreciation is also a real exchange rate depreciation, and hence the expansionary force. 

So what then is left out?   I think one problem comes with the assumption that that the central bank can still set the domestic interest rate following its usual monetary policy rule (constrained by the zero lower bound).   What the stripped down model leaves out is that central bank is only directly affecting the overnight lending rate between banks, and also possibly future expectations of this rate.  

This is where the experience of Ireland and other peripheral euro zone economies is relevant.   Stressed banks cannot access funding at the central bank’s policy rate.   This is what has led to the fragmentation of bank funding markets across the euro zone.   The weak creditworthiness of the sovereign is one of the factors affecting the creditworthiness of the banks, as the sovereign remains the primary capital backstop to the banking system.   And the high funding costs of the banks is keeping up lending rates to the real economy.  

I don’t see a reason why a similar dynamic could not play out in the UK.   Even if UK banks are in better shape than peripheral-country banks, a creditworthiness shock to the government would still be likely to affect their funding costs and thus push up borrowing rates for households and firms.  How the balance between the expansionary force from the exchange rate and the contractionary force from credit risk would play out I don’t know. 

Just to reiterate, this is not an argument that the UK faces a serious risk to its creditworthiness.   I find Simon Wren-Lewis largely persuasive on that – even if I can’t help niggling doubts.   But if a creditworthiness shock did occur, it seems unlikely that all would be for the best in the real economy.  

My colleagues at the Fiscal Council, Sebastian Barnes and Diarmaid Smyth, have produced a new report detailing a comprehensive approach to the State’s balance sheet.  The report is available here. 

I just want to underline here the value of the type of comprehensive approach developed by Sebastian and Diarmaid for policy analysis.   Policy analysis can often be distorted by taking an overly narrow view of the government accounts, and in particular focusing only on the General Government accounts.  Some examples:

In banking-related discussions, focus is often on the need for new State-provided capital and the consequent implications for Gross Government Debt.  But even if the new round of stress tests do not reveal the need for new capital, any newly revealed losses are real losses in terms of the net worth of the State.  On the other hand, additional capital required to meet more ambitious capital adequacy ratios need not lead to a reduction in net worth. 

In the discussion of “stimulus programmes”, attention is often on forms of financing that run down State financial assets or use “off-balance sheet” forms of financing.   The latter are typically off-balance sheet only to the extent that the liabilities – actual and contingent – are outside of the General Government accounts.   They are very much on a more comprehensively measured balance sheet for the State.

Finally, in the discussion of the benefits from the promissory notes transactions, most attention is given to the impact on the General Government deficit, including the roughly €1 billion reduction in the deficit for 2014 and 2015.  This particular reduction is largely an accounting fiction that follows from the limitations of General Government accounting.   It is the result of the high interest rate that was paid on PNs.  Sebastian and Diarmaid’s analysis shows the irrelevance of this interest rate from a comprehensive balance-sheet perspective (see also this recent post by Seamus Coffey).   However, they show that the transactions are likely to generate a significant net present value gain when account is taken of the effects on all the relevant entities on the comprehensive State balance sheet, although the size of that gain is uncertain and depends on such factors as the choice of discount rate and the future evolution of the risk premium on Irish debt. 

Ashoka Mody offers another thoughtful perspective on Ireland’s crisis resolution effort on today’s This Week programme on RTE radio (audio here; scroll down to last item).    Although he covers a good deal of ground, much of which I agree with, his main recommendation is that Ireland should consider scaling back its fiscal adjustment effort.   As I note in a piece for the Business section of today’s Sunday Independent, reasonable people can disagree on the optimal speed of the adjustment given the tradeoffs involved.   But Ashoka raises the old issue of the adjustment effort being self defeating.   At the risk of repetition of past posts, I cannot see how the evidence in the Irish case bears this out.   There is, of course, wide agreement that fiscal adjustment lowers growth.  But it is a significant step from here to a claim that the adjustment is self defeating on its own terms of improving the fiscal situation.   I think it is worthwhile to continue to scrutinise this claim.   

The self-defeating hypothesis comes in a number of forms depending on the focal outcome variable.   For convenience I label the main forms as: the strong form (underlying primary deficit); the semi-strong form (debt to GDP ratio); and the weak form (creditworthiness).   Ashoka’s main focus is on the semi-strong version, but it is worthwhile to briefly review the case for each.  

Ireland’s underlying General Government primary deficit has fallen from a peak of 9.3 percent of GDP in 2009 to a projected 2.5 percent this year.   This occurred despite the massive non-austerity related headwinds the economy faced.   All else equal, if there had been no adjustment from 2009, simulations show the underlying primary deficit would have reached 14.5 percent of GDP this year.   The underlying actual deficit and debt to GDP ratio would have been 20.5 and 160 percent of GDP respectively.    Of course, something would have given before these ratios were reached, but it is useful to consider the crude counterfactual in assessing what has been achieved.  (These simulations assume a reduced-form deficit multiplier of 0.5 and an automatic stabiliser coefficient of 0.4.  The underlying model being used is sketched here. ) 

Turning to the semi-strong form (Ashoka’s main focus in the interview), it is well known that for multipliers around unity fiscal adjustment can lead to a short-run rise in the debt to GDP ratio.   The reason is that the negative effect on the denominator can swamp any positive effect on the numerator.   But this static analysis can give a very misleading picture of the impact of the adjustment on the path of the debt to GDP ratio.  

This is most easily seen using the classic equation for the evolution of the debt to GDP ratio: ∆d = (i – g)d_-1 + pd, where d is the debt to GDP ratio, i is the interest rate, g is the growth rate, and pd the primary deficit as a share of GDP.   The debt to GDP ratio may rise initially due to the adverse effect on g.   But the effect of this year’s adjustment on g should be temporary while the impact on the primary deficit should be permanent.   The permanent effect should quickly swamp the temporary effect, leading to an improvement in the debt to GDP profile as a result of this year’s adjustment.   (One thing that could overturn this result is that today’s adjustment leaves a long negative shadow on the level of GDP (what is known as hysteresis), but that would again require that today’s adjustment causes the primary deficit to rise rather than fall.) 

Simulations for Ireland show that an additional €1 billion of adjustment in 2014 would only lead to a higher debt to GDP ratio in 2015 for values of the reduced-form deficit multiplier greater than 2.3 – above any reasonable estimate for the highly open Irish economy.   Reduced austerity might well improve growth performance, but it seems highly unlikely that it would improve Ireland’s debt dynamics as Ashoka claims. 

Turning finally to the weak form, it is possible the direct adverse growth effects from fiscal adjustment on investor confidence could swamp any positive effect through the deficit and debt.   This might happen, for example, if investors worry that the deeper recession would undermine political support for the adjustment effort.   It is thus possible that despite the positive fiscal impacts, creditworthiness (as measured by secondary market bond spreads) might deteriorate.  This is ultimately an empirical question.   But the fall in Ireland’s 10-year bond yield from 14 percent in mid 2011 to below 4 percent today hardly suggests that Ireland’s fiscal adjustment effort has been self-defeating on even this weak definition.  

With advance apologies for a too self-referential post, I think it might be useful to put my response to commenter Shay Begorrah from Tuesday’s thread on the front page.   Shay clearly sees me as an unabashed fiscal hawk, where more deficit reduction (and more expenditure-focused deficit reduction) is always better.   As this is not at all my view, and given my official role through the fiscal council, it might be worthwhile to explain my actual view a bit. 

During 2009 and the first half of 2010, the main thrust of my fiscal policy posts on IrishEconomy was that the fiscal adjustment was too frontloaded (see, e.g., here).    At the time I assumed that Ireland’s credtiworthiness was reasonably robust.   I underestimated how fragile Ireland’s creditworthiness  was in the context of monetary union with an underdeveloped lender of last resort to governments.   My basic approach to fiscal policy is Keynesian.   But since the middle of 2010 it has been clear to me that fiscal policy must steer a difficult course between supporting demand and sustaining the borrowing capacity of the State.   Not least, the latter is essential to ensure that the fiscal adjustment can be phased in any sort of reasonable way, and thus to sustain the essential protections and services of the welfare state. 

The idea that there is a trade off between demand and creditworthiness is challenged from both right and left.   From the right, the idea of an expansionary fiscal contraction is invoked: discretionary deficit reduction would then increase demand, further enhancing the deficit reduction.   I do not read the available evidence as supporting this contention (see, e.g., the important work from the IMF).   From the left, the idea of self- defeating austerity is invoked.   This comes in different forms: discretionary deficit reduction does not actually reduce the deficit; discretionary deficit reduction does not reduce debt to GDP ratio; and discretionary deficit reduction does not improve creditworthiness.    I do not believe that such self-defeating effects are borne out by the Irish experience (see Box C, p. 46 here).  

Another thrust (obsession?) of my more recent posts has been the critical importance to more robust creditworthiness of strengthening the crisis resolution mechanisms – and more narrowly the fiscal lender of last resort function – for the euro zone.   The political economy of such developments must been seen in the context of weak solidarity between what is an association of nation states, where there is a reluctance to risk transfers and a fear of moral hazard.  While I believe the aggregate fiscal stance of the euro zone has been significantly too tight from an optimal fiscal policy perspective, the strengthening of fiscal rules must also be viewed in terms of the political economy of strengthening the LOLR function.   The fiscal compact, for example, must be seen in this light. 

Finally, on the relative measures of expenditure- and tax-based adjustments, my prior belief around 2009 based on the literature was that expenditure-based adjustments were less contractionary than the tax-based alternative.  (Of course, in deciding on the mix of adjustments, other factors besides the macro effects – such as fairness – are important.)  From the more recent evidence, I have become much less convinced of the macroeconomic superiority of expenditure-based adjustments.   This issue was discussed in the first fiscal council report in October 2011 (see Box 4.1, p. 36, here; a more general review of the multiplier literature is given in Appendix E, p. 93, here).   The inconclusiveness of the evidence is the reason that the council has focused on an overall deficit multiplier in our analysis.

Giancarlo Corsetti and Luca Dedola have a really good VoxEU piece on how cooperation between the central bank and the fiscal authority can avoid the “bad equilibrium” problem for sovereign debt.   The paper on which the Vox article is based is available here; Paul Krugman discusses it here.  

Although the initial focus is on a country with control over its own “printing press”, they also examine how it could work in a monetary union.   I won’t try to summarize the subtle analysis, but the key is how the difference between the interest rates on sovereign debt and central bank reserves can be used to lower the cost of funding below the level that triggers the bad equilibrium.   In contrast to claims that potential central bank intervention has to be unlimited, a central finding is that limited central bank intervention may be sufficient to avoid a bad equilibrium. 

In regard to how it might work in a monetary union, a sting in the tail comes in the last sentence of their closing paragraph.  

The analysis here bears key lessons for the current debate on sovereign default in a monetary union:

·        Countries in a monetary union could indeed be more vulnerable to debt crises, to the extent that the common central bank cannot count on the joint support of national fiscal authorities;

·        The common central bank, however, still has the power to engineer successful interventions.

In doing so, it will have to weigh the benefits and costs of providing a backstop to countries exposed to debt crises, possibly drawing on seignorage accruing to all countries in the union.

“[D]rawing on the seignorage accruing to all countries in the union” raises the familiar political-economy of-transfer-risk problem that has complicated the task of stabilising stressed euro zone sovereign debt markets. 

Apologies for the belated response to Paul Krugman’s post on Ireland (linked to here by Stephen last week).   Paul focuses on Ireland’s poor post-crisis growth performance, noting that real GDP is still well below its peak at the end of the property/credit bubble.   There is no disagreement that the growth performance – and especially the performance domestic demand – has been weak.   This reflects a combination of harsh austerity measures, distressed balance sheets and the weak performance of Ireland’s trading partners. 

This graph extends the real GDP series further back in time.   In judging the continuing shortfall from the peak in 2008, we should not forget the unsustainability of the bubble-driven growth that took place from 2002 onwards.   It is also worth noting that the recent flatness of the GDP graph hides a marked slowdown in net export growth (mainly due to the weak performance of the UK and euro zone economies) combined with tentative signs of a stabilisation in domestic demand (see here). 

But any assessment of Ireland’s progress is incomplete without also looking at this picture.  From early 2010 to mid 2011 Ireland steadily lost its capacity to borrow from financial markets.   It is noteworthy that creditworthiness continued to erode in the months after entering into the Troika programme.   This reflected bad news on fundamentals – notably the size of banking-related losses – but also bad signals about the emerging nature of the euro zone’s lender of last resort in terms of the potential for forced debt restructurings and the seniority of official creditors.   The interaction of better news on the a LOLR (most recently the announcement of the ECB’s OMT programme) and the demonstration that Ireland could meet conditions for official assistance has led to a dramatic fall in borrowing costs.  

Given where we were in mid 2011 – particularly the danger of a default that would have added another vicious twist to the adverse feedback loops that laid the economy low – I can’t see how a fair assessment can leave the creditworthiness developments out.

Following the influential work of Paul De Grauwe and Yuemei Ji, the idea that bond yield crises in the eurozone reflect liquidity (i.e. multiple equilibia) rather solvency has taken hold.   (See, for example, Paul Krugman linking to a post by Joe Weisenthal.)  The main evidence is the synchronised fall in yields when the ECB strengthened the LOLR regime with the annoucement of Outright Monetary Transactions (OMT), and also (indirectly) with the LTRO programme.   This leads to the view that the tough fiscal adjustment programmes are not required for countries to regain creditworthiness.   Here is Joe Weisenthal’s conclusion:

So we can trace the two peaks of Eurozone debt stress directly to two times the ECB intervened. Austerity has had nothing to do with the improvement in borrowing costs.

But is this account too simple?   In one sense I would possibly go even further than De Grauwe and Li: in the context of monetary union, vulnerable countries will not be able to avoid the bad equilibrium without a credible LOLR.   However, I also think it is important to recognise that what is fitfully emerging is a conditional LOLR.    Countries will only get support if they are undergoing required adjustments (OMT description here).   The announcement of OMT would then not help a country if investors believed it would not take the actions that would make it eligible.   The LOLR and the adjustments are then both necessary to prevent or reverse the slide to a bad equilibrium.   

Of course, it could still be argued that the explicit or implicit conditionality is inappropriately demanding (e.g., focusing too much on reductions in the actual deficit as opposed to the structural deficit).    But given the regime as it is, the existence of OMT does not obviate the need for fiscal adjustments to steer clear of the bad equilibrium trap.

Olivier Blanchard and Daniel Leigh provide a good account of the trade-off facing policy makers in identifying the optimal speed of fiscal adjustment.   See also Chapter 2 of the IMF’s recent Fiscal Monitor.   Reasons for slower adjustment include time-varying multipliers, the danger of “stall speed” where adverse feedback loops kick in at low or negative growth rates, and hysteresis effects from fiscal contractions that are worse when the economy is already in recession.   The main reason for faster adjustment is the danger of falling into a bad equilibrium with high interest rates and high expectations of default, especially where it is difficult to credibly commit to future adjustments.  

Simon Wren-Lewis gives a sceptical response here.  Paul Krugman responds here, here and here.  

The debate focuses mainly on the trade-off for a country such as the UK that retains its own independent monetary policy.   In contrast to the uncertainty that surrounds such empirical questions as the size of fiscal multipliers or the causal link from debt to growth, recent experience in Ireland and elsewhere shows that the risk of falling into a “bad equilibrium” is not hypothetical for a high-debt country within EMU.   For fragile EMU members, an additional factor is the existence of a conditional lender of last resort, where one of the conditions for support could be a forced restructuring of privately held debt (PSI).   (I make an initial stab at integrating a conditional LOLR into a model with possible multiple equilibria here)

Interesting proposals here.

This speech by Mario Draghi is generating some interest in comments.   It usefully puts the ECB’s approach to monetary policy during the crisis in a comparative perspective. 

Some complementary reading: Paul Krugman on euro area macro policy; Simon Wren-Lewis and Antonio Fatas on the dual mandate; Janet Yellen on communication/expectations management at the Fed; and Gavyn Davies on inflation targeting.   On the subject of inflation targeting, this new Vox ebook contains a number of interesting perspectives, including chapters by Stefan Gerlach and Karl Whelan (pdf here). 

Putting questions of immediate political feasibility aside, Simon Wren-Lewis asks in a new post if there is a better approach to establishing a fiscal Lender of Last Resort (LOLR) for the eurozone. 

As Simon notes, I expressed some sympathy for the Commission in a previous post.    The Commission recognises the fragility of the eurozone in the absence of a LOLR.   This follows from the well-know multiple equilibria problem (see here).   There is good equilibrium with low expectations of default and consequent low interest rates, creating a debt sustainability situation that validates the initial expectations.  But there is also a bad equilibrium with high expectations of default and consequent high interest rates, again creating a debt sustainability situation that validates the initial expectations.   In part to develop the political support for a fiscal LOLR to coordinate expectations around the good equilibrium (where it is thought to exist), the Commission has pushed the strengthening of fiscal rules and support programmes for countries in difficulty that lean heavily fiscal (and other) conditionality and intrusive surveillance.   

 Simon usefully asks it there is a better way, while recognising the huge political obstacles at present.   His proposal centres on a significant change in the approach to OMT.   Based on an assessment of debt sustainability by a collective of independent fiscal councils – effectively an assessment of whether a good equilibrium exists – the ECB would commit to the necessary bond market interventions to keep interest rates low.   Assuming no change in its mandate, the rationale for the ECB’s participation would presumably be that it would otherwise be unable to operate a single monetary policy where, without their own central bank capable of acting as a LOLR, many countries in the eurozone are susceptible to falling into a bad equilibrium, with the added risk the entire single currency project could unravel.   One question is whether countries facing debt sustainability concerns would be politically capable of making the necessary difficult adjustments without in the absence of programmes with explicit conditionality.

Another dimension of Simon’s proposal is that the fiscal rules should become more sensitive to the aggregate fiscal stance of the eurozone in the context of a zero lower bound on monetary policy, with the obligation to adopt less contractionary policies falling on countries with stronger fiscal positions. 

It is interesting to contrast this proposal with the recent widely discussed observations of Ashoka Mody on the relative merits of adjustment/assistance and default as a means of dealing with debt sustainability challenges (Morning Ireland interview here).    Ashoka’s view is informed by his reading of history of sovereign defaults as involving relatively low output costs.   A rather different reading of the history is given in this survey of the literature on sovereign defaults.    Moving to a regime with a low default trigger would also make private investors extremely wary of sovereign debt, increasing the fragility of market access.   For the long-term, such a low moral-hazard regime certainly has attractions — but it would be one hell of ride along the way.    

Simon Wren-Lewis has a typically thoughtful post on the European Commission’s approach to fiscal adjustment as set out by Buti and Carnot in a post linked to by Philip a couple of weeks back.   In the context of the zero lower bound constraint on monetary policy, it is hard to disagree with him on the inappropriate aggregate stance of eurozone fiscal policy.  

But I think his discussion neglects an important second dimension of the challenge faced by the Commission (and indeed the ECB).   In addition to being in recession, the fiscal lender of resort (LOLR) function is still a work in progress.   This function has come a considerable way since early 2011, when a hard line on official creditor seniority, and the threat of a low trigger for PSI in future bail out programmes, pushed Ireland  and Portugal – followed not far behind by Italy and Spain – deep into “bad equilibrium” territory.   (Some thoughts from the time here.)   In strengthening the lender of last function, the Commission is constrained by the concerns of stronger countries about the fiscal risks they are taking on, which they see as further aggravated by moral hazard.  

(Sometimes I do wonder if the reluctance on LOLR can be fully explained by conflicting interests.   Although it relates more to banking side, the recent comments – even if partially retracted – by the new Eurogroup head does give cause for concern about the appreciation for the importance of the LOLR for avoiding a serious escalation of the eurozone crisis.)   

The Fiscal Treaty, for example, must be seen as part of the quid pro quo for developing the LOLR.   The ESM – absent some of the more damaging elements of the original proposal – and the ECB’s OMT programme would be unlikely without the strengthening of the rules-based framework.    This must be balanced by the Commission against unwelcome implications of the rules for the aggregate fiscal stance.  

Given their advocacy for a strengthened LOLR, I do think the Commission sometimes gets a bum rap.

The IMF has a useful new paper on the possibility of self-defeating austerity.    Paul Krugman responds here.   The paper shows that fiscal adjustments will bring the debt to GDP ratio down over time relative to a no-adjustment baseline, although the ratio will rise in the short run when the multiplier is greater than one.   For the Irish case, this phenomenon was pointed out in the April 2012 Fiscal Assessment Report from the Irish Fiscal Advisory Council (see Box C, p. 45).   See also posts here and here.    The IMF paper also has an interesting suggestion for setting and monitoring debt targets in cyclically adjusted terms. 

What does economics say about the optimal response to a positive shock to nominal government debt – say an increase due to the costs of funding a bank bailout or an increase that results from automatic stabilisers in a recession?   From many recent statements I have seen, there seems to be something close to a conventional wisdom that the increase in the debt does not have to be reversed.   It is only necessary to increase the primary surplus to pay the interest on the higher debt, or, even better, to fund the difference in the nominal interest and nominal growth rate times the increase in debt. 

The logic for this position comes from Robert Barro’s classic tax smoothing paper (Barro, 1979).   Given that distortions rise non-linearly with the tax rate, Barro shows it is optimal to maintain constant tax rates over time for a given path of government spending.   A surprising implication is that a shock to the debt to GDP ratio should be accommodated in the sense that the ratio should be allowed to rise permanently.   This leads to the optimal debt ratio to follow a “random walk”, allowing the ratio to be pushed around by debt shocks.   (See Section 2 of this paper for a nice exposition.)

But is this result too comforting?   As Simon Wren Lewis has pointed out in a number of insightful posts and papers (see here and here), the result depends on Barro’s assumption of altruistically linked generations.   The result does not hold in an overlapping generations (OLG) model where the interest rate is greater than the discount rate due to the limited concern for future generations.  In this model, optimal debt policy does require that the increase in the debt ratio is reversed, although the optimal timeframe for the reversal can be very long.  (Simon is at pains to note that this should not stop the use of countercyclical policy in a recession.) 

Another critical implicit assumption in the Barro model is that the Government’s creditworthiness is not an issue.   This may be a reasonable assumption for a country such as the US that has its own central bank, which could print money to avoid default in extremis.   But recent experience has taught a hard lesson about the fragility of creditworthiness in an economy such as Ireland’s.   Suppose that the debt to GDP ratio has to be below, say, 80 percent of GDP to ensure robust creditworthiness.   For a given path of nominal GDP, the increase in nominal debt due to the shock will have to be reversed – and possibly quite quickly.   (This does not necessarily mean that nominal debt will actually have to be cut; but increases in nominal debt that would have been feasible due to nominal GDP growth must now be foregone.)  

Finally, the result does not allow for rules on the maximum allowable debt to GDP ratio.   Under the SGP and fiscal treaty, the maximum allowable debt ratio is 60 percent of GDP.   Again, any shock to the nominal debt will have to be reversed, even if the time frame under the rules for bringing the debt ratio to the target can be fairly long. 

The bottom line is not a welcome one.   Nominal debt shocks have to be reversed (eventually), not accommodated.    

I give my take on last week’s deal today in the Sunday Business Post.   Cliff Taylor has kindly allowed an unedited version to be posted here.  

After the drama of Wednesday’s late-night liquidation of IBRC, attention turned on Thursday to attempts to make sense of the deal on the promissory notes.  To assess the merits of the deal, economists were looking for answers to four big questions: How would the deal affect the burden of the IBRC debt as measured by the present value of the state’s obligations?   How would it affect the funding pressures on the state over the next decade?   What would be the impact on the General Government deficit and thus on need for further austerity measures?   And would the deal ease the precarious position of having to get ECB approval of Exceptional Liquidity Assistance every two weeks?  

We must follow the money the money to answer these questions. Continue reading “Follow the money to find answers”

Too good to miss . . .

Re Box 6, By Gavin Kostick

[Scene: A spacious drawing room in Frankfurt. A patient is strapped to a table. M Drachet in attendance, plus admirers]

M Drachet: Our diagnosis for this fellow is an excess of partying, too much of the punch-bowl, a surfeit of humours, grass corpulence and a palpable debt overhang. Our remedy? Leeches!

[Enter Mr deKrugman, a plain talking Yankee]

Mr deKrugman: Hold your hand, sir! The patient is week. Leeches will only distress his condition further.

M Drachet: Oh that annoying fellow. Even your fellow Americans agree that leeches are the cure.

Mr deKrugman: Not any more they don’t. They’ve changed their minds.

M Drachet: Really? Never mind – bring on the leeches.

Mr deKrugman: Rather than leeches, this fellow needs an infusion of fresh blood to recover.

M Drachet: Are you volunteering?

Mr deKrugman: You, sir, can create all the blood you wish and you know it.

M Drachet: Balderdash.

[A fop whispers in M Drachet’s ear]

M Drachet: Well that’s news. But you forget, our medical charter expressly forbids it. And you miss the nicer point, if we were to do so, this fellow would learn nothing from his foolishness and return to his profligate ways.

Mr deKrugman: Are you trying to cure the fellow, or teach him a lesson?

M Drachet: A soupcon of A and a morsel of B. Now, the leeches.

[The leeches are applied, and the patient becomes noticeably paler]

Mr deKrugman: Told you.

M Drachet: You really are the most arrogant fellow.

Mr deKrugman: Says the man with the leeches.

M Drachet: But this is part of the cure! You see he is being purged, in in being purged he will ultimately return stronger.

Mr deKrugman: Or dead like that poor Greek fellow.

M Drachet: And anyway, you quite misunderstand. It is not the leeches that make him pale, but, er, that, that and la bas!

Mr deKrugman: You’re pointing at a bunch of random things.

M Drachet: Not at all, I’m pointing at fetid air! Contagion I tell you. Stop looking at the leeches.

Mr deKrugman. Look, are the leeches to teach a painful lesson or to help the patient get better?

M Drachet: Can they be both?

Mr deKrugman: No.

M Drachet: To be honest monsieur, we do it because we’ve always done it.
But our meticulous research shows that if the patients have, er, died in the past – it wasn’t the leeches fault! It was, um, something else!

Mr deKrugman: I strongly recommend an infusion of fresh blood.

M Drachet: But if we tried something new and it proved better, why our reputation for competence would be in tatters – you laugh sir?

Mr deKrugman: No sir, I weep. I weep.

[They continue to bicker as the bloated leeches suck happily at the patient]

The Sunday Business Post’s Money section has an article on the possibility of not renewing the Eligible Liabilities Guarantee (ELG) when it expires at the end of the year.   (A FAQ on the guarantee is available here.)   The article focuses on arguments made by Wilbur Ross for not renewing the guarantee. 

Ross, who owns 7.7 percent of Ireland’s only privately-controlled bank and sits on its Board, told The Sunday Business Post that the extended liabilities guarantee (ELG) was “severely impeding the recovery of the banks” because of its high cost and should be scrapped.

“There is no reason for [the] government to extend the ELG,” he said.   “Ending [it] will be viewed favourably by the markets as a major step toward the normalisation of Ireland’s financial system and will facilitate the sovereign’s access to international credit markets.”

Ross said that the low interest rate environment, combined with the high cost of the ELG, which will cost Bank of Ireland €400 million this year, was keeping the banking system from returning to profitability.

An aspect worth considering is that, even if the explicit guarantee is not renewed, past experience suggests that the liabilities in question will be implicitly guaranteed at zero cost to an 85 percent privately owned bank.

As linked to by Philip below, Ashoka Mody reignites debate on the default option.   His views must be taken seriously given his vast experience on economic crises.   But it is important to put his proposals in context.   They are largely aimed at European policy makers.   A large private/official-sector debt write off, followed by a commitment to provide necessary funding support as countries moved in a phased way to the low debt/balanced budget model common for states in the US, could well be a route out of the current crisis.

The problem is that this option is not on offer.   In these circumstances, the more a default option is kept on the table as a possible future choice, the harder it will be to regain creditworthiness.   Who would want to buy Irish bonds now if they stand a significant prospect of facing write-downs on their investments in the future?    To the extent that expectations of default remain high, the concern is that it would be less than the orderly/supported model described by Ashoka.   The evidence from past defaults is that they come with large output costs.   The fear of the crisis entering a new virulent phase would undermine confidence and growth in the present, making it harder to stabilise the vicious feedback loops between the banking, fiscal and real sectors. 

An implication is that it is important to move decisively in one direction or the other.   Either get on with the type of solution proposed in the article or take the default option off the table to the maximum extent possible.   With the first option not actually available, the Irish government have moved in the second direction – with reasonably good results in terms of the restoration of creditworthiness.    This option can only work with a strengthened institutional structure for EMU – Patrick Honohan’s euro 2.0.    A core component must be a strengthened lender of last resort for sovereigns backed by fiscal rules that limit risk and moral hazard.   The ECB’s OMT programme – however rationalised by the ECB itself – is an important step in this direction, but more needs to be done.

The Commission has provided a useful contribution to the size of fiscal multiplier debate.    The disagreements between different analyses are not really surprising given the limited number of observations everyone has to work with.   A particularly useful addition is the addition of controls for sovereign default premia.    The literature on sovereign default has emphasized the output costs associated with default (see here), even if the channels of causality are murky.   This is likely to lead to a significant “fear of default” effect on growth, underling the importance of lowering default risk in the broad crisis-resolution effort. 

But in one important respect the Commission lets itself off the hook too easily.   Rightly recognising the importance of lowering sovereign bond yields (and with it the perceived probability of a default on private bond holders), it emphasises the importance of lowering debt to GDP ratios.

When discussing the negative short-term output costs of consolidation it is important not to lose sight of what the counterfactual would be. For the most vulnerable countries, exposure to financial market pressures means there is no alternative than to pursue consolidation measures. The alternative of rising risk premia and higher borrowing costs would be worse for these countries, and consolidations are needed to restore fiscal positions and put debt projections back on a sustainable path.

However, for countries without their own central bank to act as lender of last resort (LOLR) in extremis, and with high debt/deficit levels and weak/uncertain growth prospects, creditworthiness will be fragile for the foreseeable future.   Central to creditworthiness will be design of euro zone LOLR arrangements.   Modest reductions in official debt will not change this underlying fact – though would certainly help.   I think Ireland stands a reasonable chance of avoiding a formal second bailout programme.   But we should not forget that if it does avoid such a programme, it will be significantly because of the available of a quality LOLR backup, possibly through the OMT programme.  

The fiscal adjustment conditions underlying this back up should be: (i) reasonable (i.e. do not push the capacity of a government to deliver fiscal adjustment beyond breaking point; (ii) reliable (i.e. investors should be confident that the support will be there without a forced private-sector default); (iii) flexible (i.e. the conditions should not be designed so that the country is forced to pursue ever larger fiscal adjustments if growth disappoints; and (iv) the link between bank losses and sovereign debt should be broken (taking away a lingering source of uncertainty about the country’s true fiscal position.  

The Commission clearly believes that it is critical for credibility that governments meet the nominal budget deficit to GDP targets set down in their programmes.   But what it is really important is that it is credible that the government will meet its conditions – which could be made growth contingent.  

It has to be recognised that such arrangements do require that the stronger euro zone countries take on substantial risk.   We have to accept that the quid pro quo for this will be stronger collective rules and surveillance.   It is a two-way process. 

For the Irish case, there is a common interest in supporting a “well-performing adjustment programme” to demonstrate that this approach can work.   Part of this could be relieving the burden of official debt, with a restructuring of the PN/ELA arrangements holding the most promise.   But the design of ongoing LOLR arrangements is also critical.   The good thing about a mutual advantage argument is that it does not depend on allocating blame for past “sins”.   There is plenty of blame to go around.   But as Derek Scally argues today, arguments based on blame are unlikely to get us very far.  

Colm can correct me, but I think the title of the article does not capture the substance of the piece.   I don’t think Colm is advocating abandoning the euro, but rather fixing its current inadequate structure, including putting in place an adequate banking union and effective lender of last resort to states.  

From the article:

The broken Eurozone project needs two sets of policy actions. The first, for the long term, is a re-engineered monetary union designed to survive, which means a banking union and a more centralised system of macroeconomic management. The second, and more contentious, is a clean-up operation to restore prospects of economic recovery, especially in the growing list of financially distressed members.

To date, the performance of the Eurozone political leadership has been dismal, inviting unfavourable comparisons to the more decisive actions of the US Treasury and Federal Reserve.

The clean-up operation needs a coherent macroeconomic strategy at European level as well as an acceptance that the debt burdens remaining on several Eurozone members need to be relieved. The macroeconomic strategy should see a relaxation of fiscal consolidation in those countries which retain good access to bond markets, as well as a deliberately expansionary monetary policy from the European Central Bank. Some weakening in the external value of the euro should be seen as a minor concern. If the current growth standstill continues it may ultimately weaken anyway.

It is fashionable in Germany to argue that Europe needs greater political union, permitting a more centralised fiscal policy. If the Eurozone were already a single country, with a normal central bank and a counter-cyclical macroeconomic strategy, it would already be seeking to bolster aggregate demand as the US has been doing. The zone as a whole does not face an imminent inflation threat, does not have a balance of payments deficit and has public debt and deficit ratios no worse than those in the US, the United Kingdom or Japan. But it remains committed to a policy stance that is exacerbating the downturn, particularly in the regions of the Eurozone facing financial distress.

In addition to a relaxation of policy at Eurozone level, a pragmatic approach needs to be taken to the debt-encumbered member states. Greece will have to undertake another debt restructuring, perhaps fairly soon. Several other countries may be unable to carry the burden of debt which has been accumulated. A partial mutualisation of excess debt burdens is the other essential component in the clean-up operation, preferably on a no-fault basis. This will likely happen in a messy and politicised manner anyway. Better to accept that debt burdens in excess of some agreed threshold be addressed, through further haircuts for private creditors in some cases, some monetisation by the ECB and some mutualisation by Eurozone rescue vehicles. Peripheral states in trouble could expect to see a reversal of capital outflows, with a consequent reduction in borrowing costs. If this kind of clean-up operation requires treaty changes, so be it. The Irish Government is understandably wary of changes given the mixed record on getting EU-related referenda passed, but if treaty change is the price of a durable solution it should be considered on its merits.

One place where I might disagree with Colm is where he calls for “further haircuts for private creditors in some cases”.   He is of course right that such haircuts cannot be ruled out; and, in the case of Greece, it is hard to see them being avoided.   But it is a truism to say that it is the fear of such haircuts that leaves a country struggling for creditworthiness.   Where there is a reasonable path through the crisis without such haircuts, the strategy should be to take the possibility off the table to the greatest extent possible.   This does not mean there should not be relief on official debts.   The Sunday Business Post piece “State edges closer to ECB deal on promissory note” (no link available) gives one encouraging note in today’s papers.

Dawn and Jonathan have been kind enough to reply to the post below.   Many thanks to regular commenter David O’Donnell for bringing the post to their attention. 

We are grateful to John McHale (and others on this site ) for these very thoughtful comments.

First, we should emphasise that NIESR does not have the detailed specific expertise on the Irish economy of many of those commenting here: given that NiGEM is a global macroeconometric model, the Irish economy component is inevitably quite stylised, and can’t take account of some of the specific features of the Irish economy which John and other commenters have rightly highlighted. The fact that our calculations suggest that fiscal consolidation is less damaging in Ireland than in other countries reflects relatively low estimated multipliers, even in current circumstances. But the NiGEM multipliers may well overstate the extent of import leakages, given the specific structure of Irish trade, so actual multipliers might be higher than our model estimates suggest. We should also note that the fact that, in contrast to other countries, our estimates suggest fiscal consolidation has in fact reduced debt-GDP ratios in Ireland does not any measure imply that we think it was the optimal policy (see below).

There are two important general points John makes.

First, he points out that while our simulations show that debt-GDP ratios will be higher in 2013 (in all countries except Ireland!) than they would have been without fiscal consolidation, primary deficits will be lower, and in the long run the binding solvency constraint is the intertemporal government budget constraint. This is absolutely correct. Postponing fiscal consolidation doesn’t mean that it isn’t ultimately necessary in EU countries – almost all of them – that have significant structural primary deficits. The main point of the paper is that the negative impact on GDP, and hence on the amount of consolidation required, is much larger if you frontload consolidation during a period when multipliers are much larger. Later consolidation could have been both smaller and less damaging. We have not attempted to illustrate such an alternative path (and of course the “optimal” path depends on future economic developments) but certainly delaying would have been better. This is also true for Ireland.

Second, he notes that we omit any analysis or discussion of hysteresis. We agree entirely that this is a very important issue when considering the impact and timing of consolidation. In an earlier paper, Bagaria et al (see Vox here) we perform a similar, but more detailed, analysis for the UK, incorporating labour market hysteresis effects (but ignoring spillovers). In this (in contrast to Delong and Summers), we do exactly what John suggests, which is to assume that hysteresis effects matter but decay over time. Ideally we would indeed do the same for Ireland and other EU economies, but this is a somewhat more complex exercise.

As the note by Holland and Portes linked to earlier by Stephen is likely to be influential in the fiscal policy debate, it is worth taking a closer look at the findings with the Irish case in mind.   The note is based on a more detailed (and very useful) analysis by Dawn Holland (available here). 

Although the main message on the impact of (coordinated) fiscal adjustment is quite negative, the fact that Ireland is the only country for which the adjustment leads to a (small) fall in the debt to GDP ratio might appear to give some comfort.   But I don’t think we can take comfort on the score.   Not surprisingly, the reason Ireland stands out as an outlier in this analysis is because of relatively small (normal-case) multipliers.   (The multipliers are assumed to be higher in the context of the current crisis, but the precise “crisis multipliers” used for Ireland are not given in the paper.)  The assumed normal-case multiplier is -0.36 for a decrease in government consumption and -0.08 for an increase in income taxes.   I would guess that the relatively low assumed normal-case multipliers for Ireland reflect Ireland’s high imports as a fraction of GDP.   But as discussed here, a large fraction of imports in Ireland are used as inputs into the production of exports.   As a result, the high import share can give a misleading view of the marginal propensity to import out of domestic demand.   Controlling for exports, a simple regression shows that a one euro increase in domestic demand is estimated to raise imports by 0.23 euro, indicating substantially less leakage from expansions in domestic demand than the crude import share would suggest. 

While I don’t think we can get any comfort from Ireland being an outlier in the analysis, I do have concerns about the broad conclusion of the paper.   This conclusion is that fiscal adjustment has actually raised debt to GDP ratios.   To the extent that the debt to GDP ratio is critical for creditworthiness, this suggests that efforts have been self-defeating on this central measure.  Continue reading “A comment on Holland and Portes”

On the Private Debt Relief thread, commenters Brog and John Gallagher (same person?) usefully draw our attention to the debate on participation of the GSEs (Fannie Mae and Freddie Mac) in the HAMP-PRA programme (Home Affordable Modification Program – Principal Reduction Assistance).   

The federally sponsored GSEs hold a substantial fraction of US mortgages, and so their position is somewhat analogous to Ireland’s state-owned banks.   The GSEs are administered by the independent Federal Housing Finance Agency (FHFA).    John draws our attention to correspondence from the US Treasury to the agency, urging its participation in the HAMP-PRA programme.    (See here; speech by head of FHFA at the Brookings Institution here.) This program, one of a number in operation to improve the functioning of the US housing market, provides subsidies to mortgage holders for principal reductions.   The gist of the correspondence is that such reductions could, depending on the case, have a positive net present value for the owner of the mortgage.   Indeed, it is argued that the gains in NPV would more than cover the cost of the subsidy, resulting in a net gain to taxpayers.   The correspondence also discusses strategic default concerns. 

Of course, given the differences in the housing markets – e.g. the relative importance of non-recourse loans in the US – the estimations are at best suggestive for the Irish case.   But the broad approach to thinking about the issue is useful.  

One issue that is not explicitly taken into account is the possible macroeconomic benefit of facilitating household balance sheet repair.   Here again the Irish situation is different given the state creditworthiness challenge and the importance of avoiding further losses at the banks.   A programme that ends up with a net cost to the state (from combination of any subsidy and the need to inject further capital into the banks) would further erode the financial position and creditworthiness of the state.   To the extent that weaker creditworthiness (and the associated “fear of default”) feeds back to higher interest rates and lower growth this would be a macroeconomic cost.   Nevertheless, it is worth looking at how these issues are being addressed elsewhere. 

Wolfgang Munchau has another thought provoking piece in Monday’s FT.   While he believes that the announcement of the ECB’s OMT programme has stabilised things for the near term, he remains pessimistic that the crisis – which he sees as fundamentally one of solvency rather than liquidity – is on a path to being resolved. 

Although I share many of Wolfgang’s concerns, my take is a bit different.    My starting point on the solvency issue is also quite pessimistic.    Defining state solvency is not easy.   A necessary condition is clearly that the debt to income ratio is not on an explosive path.   In terms of levels, we see that some countries (Japan being the most dramatic case) appear to be able to roll over debt and fund deficits even at debt to GDP ratios in the region of 200 percent.   On the other hand, low-income countries can struggle to be creditworthy with debt to GDP ratios of 20 to 30 percent.    Lacking their own central banks that can lend to governments in their own currency in extremis, euro zone countries with high debt/deficits and weak/uncertain growth prospects have been revealed not to be creditworthy.   In a very real sense these countries would not be solvent without official sector support – and are unlikely to become so for some time.   The important question then is whether official sector policies can be designed to allow countries to be robustly creditworthy.   Designing these policies faces a double credibility hurdle: that the support will be there (if only as a backstop) if countries meet the conditions for eligibility; and that it is credible that the countries availing of the actual/backstop support can meet the conditions. 

The requirements for effective official support policies seem to be the following:  (1) Supports must be reliable – countries must be able to rely on the support being there without forced PSI as long as they continue to meet the conditions.  Where PSI is deemed to be unavoidable, this should be recognised early and done decisively so that it can be taken off the table to the maximum extent possible.    (2) The conditions must be reasonable – taking into account underlying growth prospects and the negative impacts of fiscal adjustment on growth, the required adjustments must not push the political capacities of governments to push through large adjustments beyond the breaking point.  (3) The conditionality must be flexible – unanticipated adverse growth outturns should not lead to requirements for ever larger adjustments.   And (4) the link between banking-sector losses and state debt must be broken.  

Euro zone crisis resolution policies are moving slowly in this direction, although there is some way to go on both reliability and flexibility in particular. 

Following the IMF’s new analysis on the likely size of fiscal multipliers in a liquidity trap, there is a need to revisit the appropriate conditionality regarding fiscal adjustment.    But where the current policy stance leaves huge uncertainty over whether the crisis will be resolved, this must also act as a huge break on growth.   (I discuss this further in an Irish Times piece last week.) 

Of course, the policy mix described above is a big ask for stronger countries, either directly or through the ECB.   They are being asked to take on large risks and put a lot of faith in the willingness of countries to meet the conditions.   The development of the necessary crisis resolution and prevention policies must be seen as a two-way process, where all euro zone countries submit to tighter rules on budgetary management and more intrusive surveillance (see Mario Draghi’s recent comments in an interview here).   Much of the debate in the run up to the fiscal treaty referendum seemed to completely miss this point, reaching its nadir in complaints about a “blackmail clause” regarding access to the ESM. 

I believe the crisis can be resolved.   But only if the stronger countries recognise the kind of ongoing official support regime that is required to robustly restore creditworthiness, and all countries recognise the necessary pooling of sovereignty that is required to make this regime politically feasible.