Recently I had a conversation about the Greek debt reduction of 2012 and it seems that a lot of people still analyze that period using the nominal haircuts imposed on Greek bondholders with the PSI and the debt buyback of December 2012. The reality though is that the actual reduction in the Excessive Deficit Procedure (EDP) government debt of Greece in that year was far lower.

The PSI exercise reduced Greek debt by a nominal amount of €106bn while the debt buyback resulted in another €20.5bn nominal debt haircut for a combined result of €126.5bn. Yet the PSI also involved reducing debt held by government entities (such as pension funds) which are not counted in the EDP debt (since they are intergovernmental holdings) while it also required a large increase in government liabilities in order to provide the banking system with the necessary funds for recapitalization. As a result, the stock-flow adjustment for 2012 (based on Ameco data) was only -€68bn. If one also takes into account that the 2012 government budget included €5.3bn in support for financial institutions, the end result is a haircut of only €63bn meaning that every Euro in nominal debt haircut actually reduced EDP debt by 50%.

It is true that the recapitalization also created a government asset in the form of bank shares which will result in a future improvement of the headline debt figure. Nevertheless, the Greek financial stability fund (HFSF) has already ‘lost’ close to €10.5bn in covering funding gaps while its bank shares holdings were valued at €17bn at the end of 2014Q3. It still has around €11bn in unused funds although the government’s intention is to use them in creating a ‘bad bank scheme’ to clear banks from NPLs (something with which Ι agree completely). Overall, the room for debt reduction through the HFSF assets seems a bit thin and will probably not produce a drastic improvement of the headline debt figure.

Given that the PSI did not include the SMP and ANFA holdings of the Eurosystem it resulted in a large hit on Greek debtholders with a much lower reduction of the stock-flow adjusted debt (and even of net debt). It is mostly a proof that postponing debt restructuring (and creating a debt seniority hierarchy in the meantime) almost always results in inefficient outcomes.

Since the Eurosystem will be starting its QE program purchases this month while both 3Y-LTROs have already matured I would like to take a closer look at its balance sheet, especially in comparison with the last one before the large 3Y LTROs:

Eurosystem Simple Balance Sheet 2011 and 2015

* total assets/liabilities are taken from the Eurosystem balance sheet and are not the sum of the simplified categories. Reserve requirements were 2% in 2011 instead of the current 1%.

From the asset side it is evident that bank lending is much lower even compared to financing before the LTROs while the Eurosystem securities portfolio is roughly the same as almost 3½ years ago. If one removes a bit more than €100bn from bank lending due to the lower reserve requirements it is clear that at least the sum of lending and securities are lower today than the level they reached during 2011.

Looking into the liabilities side we see that banknotes have increased by roughly €125bn while reserves are down almost €450bn. Even correcting for reserve requirements and banknotes, reserves are still roughly €200bn lower than their 2011 level. Although this cannot reflect anything other than increased ‘stability’ in the banking system, it also shows how much effort the ECB will have to exert in order to substantially increase excess reserves which currently stand at less than €200bn.

The above are also evident by looking at the chart of Eurosystem lending and security holdings which make it clear how the ECB is back to 2011Q3 levels in terms of its refinancing operations:

Eurosystem Lending and Securities Holdings 2011 - 2015

The first couple of months of ECB purchases will probably be used in order to overcome ‘inertia’ in the banking system and move excess reserves to levels that will significantly pressure money market rates. A first sign will probably be lower ‘EONIA heartbeats‘ as was the case after the settlement of the 3Y LTROs.

 EONIA 2012 - 2015

Since ELSTAT released the GDP figures for 2014Q4 recently I ‘d like to take the opportunity for a few quick comments on the Greek economy.

According to available seasonally adjusted data, Greek GDP decreased 0.4% during 2014Q4 (compared to the previous quarter). a larger movement than the 0.2% figure available in the first flash estimate. Compared to 2013Q4, it increased 1.3% compared to 2013Q4, lower than the initial 1.7% estimate. Overall, during 2014 Greek GDP registered its first increase in volume terms with a growth rate of 0.77%. Nevertheless, nominal GDP decreased significantly from €182.4bn to €179.1bn (a loss of 1.84%), implying a very large GDP deflator change of -2.61%. As a result all debt figures (which are calculated in terms of GDP) continued deteriorating during 2014. Given the ongoing deep deflation (inflation is -2.8%) it is quite possible that even a material increase in the GDP growth rate during 2015 will not be reflected in an actual increase of  nominal GDP.

Looking at the income method in current prices what is evident is the substantial increase in compensation of employees during the second half of 2014 (compared to 2013) with the seasonally adjusted figure (table 5) increasing 3.2% from €29.3bn to €30.2bn. Gross Operating Surplus on the other hand registered a significant fall from €49.84bn to €46.36bn (-7%). A large part of the fall appeared in an increase in taxes on production and imports which increased from €11.96bn to €14.18bn (+18.5%). The increase in compensation is highly important since it signals an improvement in employment (given that wages are falling or stagnant). On the other hand, the large fall in GOS (of the order of €3.5bn in half a year) is not a positive sign, especially since a large part of the fall was reflected in higher tax incomes (which increased €2.2bn during the same period).

Table 7 (which shows the chain-linked volume changes compared to the same quarter of the preceding year) paints a similar picture in terms of the tax burden with taxes on products (production method) increasing close to 7% during 2014H2. Positive signals are:

  • The stable increase in private consumption during most of 2014.
  • The almost double digit increase in exports (with the growth driven mainly by services exports) and
  • The impressive growth (+17.9%) in gross fixed capital formation during 2014Q4, especially compared to the fact that fixed investment was decreasing until 2014Q2. As long as this pattern continues it will signify a shift towards higher investment and eventually allow net investment to also become positive (and increase the Greek economy capital stock). Nevertheless, looking into the detailed breakdown of investment one will notice that the large increase was the result of a substantial (one-off?) growth of transport investment during 2014Q4 which probably reflects new ships. Construction is still in negative territory while equipment investment is only slowly starting to gain momentum.

Overall, the GDP figures provide both positive and negative signs. The large tax burden and the fall in GOS are obviously negative while the increase in labor compensation and fixed investment can become drivers of economic growth in the future (along with exports). The persistent and strong deflationary forces are the most important negative factor since they make debt stabilization a daunting task and create the need for further austerity measures.

Given the latest Greek government debt figures (2014Q3 – €315.5bn), government debt is now 176.2% of GDP. Just for comparison, the latest program review by the IMF (June 2014) was projecting 174.2% (table 1) with a nominal GDP of €181.9bn and a GDP deflator of -0.7%. If the projected figure of nominal gross debt for 2014 is reached (€317bn), then debt will reach 177%. Given the ongoing deflationary dynamics in the Greek economy it is quite probable that the ongoing negotiations about the completion of the program review between the Greek authorities and the ‘institutions’ will quickly reach the conclusion that the debt sustainability analysis is obsolete.

Lately there have been widespread fears that the Greek government might not be in a position to honor its debt repayments during March, which amount at €2.5bn (€1416mn in repayments to the IMF, €800mn in interest payments and €280mn in other obligations). Although I agree that things are getting quite tight, I do not think that a ‘failure to pay’ is imminent. Such an issue will emerge mainly during the summer (in July and August) when Greece will have to pay a total of €8.81bn (with the bulk belonging to €6.68bn of ECB SMP bonds which mature then).

Lets start from the easy facts. Greece will not be receiving any funds from the official creditors until a successful completion of the current review for the bailout package. This also includes €1.9bn in SMP profits which have already been remitted by the ECB to Eurozone countries. Moreover, the limit for short-term T-Bills issuance (at €15bn) has already been reached and the ECB/SSM does not seem to be keen in (temporarily) increasing it.

According to the BoG January data, the central government budget balance on a cash basis (which is the one we are mainly interested in) was negative both for the primary and overall figures (€150mn primary deficit and €220mn overall). At least during January, revenue registered a substantial shortfall of €1.33mn compared to the same month for 2014 which was the main factor that drove the balance to deficit compared to a positive net balance of €600mn during January 2014. Obviously, unless the Greek government succeeds in improving tax collection significantly, the revenue shortfall will quickly create very serious problems for its financial position.

Nevertheless, apart from monthly revenue and expenditure flows, the Greek government also holds substantial liquid assets. Unfortunately, most statistical data are published with large lags (for instance we still don’t have the January figures for the BoG balance sheet) and usually refer to the general government. Given that the central government is taking measures in order for general government entities to ‘invest’ their surplus funds in repos with the central government, we can draw an overall picture based on the data available.

BoG annual accounts for 2014 show that the Greek general government held around €3.5bn in its accounts at the central bank. Additionally, the BoG bank deposits data (with January figures released a few days ago) do provide a detailed breakdown of deposits by government branch:

Greek government bank deposits

It is evident that, although the government financial position has deteriorated during the last few months (with deposits falling from €14bn to €12.26bn), the central government still holds substantial liquid deposits in the banking system which stood at €6.66bn at the end of January. Moreover, social security funds held €3bn in sight deposits while local governments another €1.8bn. Obviously a large part of the above funds are used in day-to-day operations (pension payments for example exceed €2bn per month) yet clearly substantial assets exist which could be used in an ’emergency’ situation. The Greek government could also probably make use of the Greek pension funds ‘common capital’ which is invested in Greek government bonds and T-Bills and is currently valued at around €5-6bn.

Based on the government balance during January, deposit data, BoG 2014 balance sheet and debt payments in January (€1.6bn), the Greek general government should still have over €13bn in deposits at the BoG and Greek banks (the actual figure will depend on the budget execution during February). Moreover, BoG will be paying a dividend of €640mn during March which will provide a substantial windfall revenue for the government.

As a result, the actual data do not point to the Greek government having an immediate liquidity problem, at least during March. The main issue is one of a political nature since the Greek state is slowly getting inτο a position where it has to decide whether to prioritize debt repayments towards the official sector or immediate relief for its citizens while also achieving timely clearance of arrears and execution of scheduled payments. Obviously the current situation quickly reduces the government’s ‘degrees of freedom’ and strengthens the creditor position who can just ‘sit and wait’ for Syriza to slowly give in to all their demands. Given the schedule of debt repayments this stand-off will end in one form or another in the summer (June also includes a large sum of €2.62bn in payments).

One last possible problem is the ELA caps set by the ECB. In order for the Greek government to use bank deposits to pay maturing debt, the funds will have to be transferred to its account at the BoG and eventually increase Target2 liabilities. As a result, the transfer will require an equal increase in ELA financing, the terms of which (total amount and collateral framework) are set (up to a point) by the ECB governing council.

Since the second 3Y LTRO matured this week while the ECB QE starts in a few days it is interesting to take a quick look at the overall liquidity position of the European banking system. According to the latest Eurosystem weekly statement, lending through regular refinancing operations (MRO and LTROs) was €501.3bn during the preceding week (this does not include the sizable ELA lending of Greek banks which appears to have increased by €5.6bn).

Based on the outstanding OMOs, total lending now stands at €488,3bn. A large part of the maturing 3Y LTRO was replaced by higher MRO lending (which increased to €165.35bn from €122.11bn in the previous week) yet overall financing was €13bn lower and now stands at less than €500bn. In other words, total bank financing is now close to the allotted amounts of each of the two 3Y LTROs (first: €489.2bn, second: €529.5bn).

Obviously the European banking system has lowered its reliance on Eurosystem financing substantially. It seems that any increase in the Eurosystem balance sheet will only be the product of outright purchases through the ABSPP/CBPP3 and government bond program. It is even probable that individual banks will use the newly created reserves in order to reduce their reliance on Eurosystem financing and free encumbered collateral which will result in lower MRO allotments in the next few weeks. Consequently, one should observe almost immediate effects on repo market rates and turnover by the upcoming ECB QE purchases.

Since I recently submitted my MSc in Finance dissertation titled «The informational content of SMP deposit auctions in forecasting short-term repurchase agreement interest rates», I would like to take the opportunity to write a few words on its conclusions. The main objective of the research was to examine whether SMP deposit auctions carried valuable information for forecasting short-term repo rates. Since banks with excess liquidity always faced the choice between parking their reserves at the weekly term-deposits for a week or lending them in the GC repo market, SMP deposit rates should act as an effective floor on risk-free money market rates.

In order to evaluate the above hypothesis the paper first suggested a stochastic model for the bid rate in auctions (based mainly on the level of excess reserves in the system) as well as the conditional variance of the bid rate process (the calculation suggested that the variance was not steady but a function of excess reserves therefore implying that a possible econometric specification would face heteroskedasticity problems).

The econometric specification used a cointegrating relationship between the weekly GC and SMP deposits rate in a VEC model also containing excess bids, number of bids and the VIX index (as a proxy of market stress) as explanatory variables. A competing VAR model of the MRO and GC rate was estimated and out of sample forecasts of the GC rate for the two models were compared. The results clearly indicated that the SMP deposits did provide significant informational content for short-term money market rates.

A few people might find the (very) large section in monetary policy and repo market details informative and helpful. Overall the paper is quite technical but I hope relevant for evaluating the effectiveness of certain sterilization tools used by central banks in recent years. It might prove useful in analyzing related facilities used by the Federal Reserve (such as Interest on Reserves and the overnight and term reverse repo facilities), a topic that interests myself as well.

Το ΚΕΠΕ στο μηνιαίο δελτίο οικονομικών εξελίξεων του Ιανουαρίου 2015 συμπεριέλαβε ένα άρθρο πάνω στους δημοσιονομικούς πολλαπλασιαστές της χώρας το οποίο έλαβε αρκετά μεγάλη κάλυψη στον τύπο (όπως θα ήταν αναμενόμενο άλλωστε). Μιας και το θέμα των πολλαπλασιαστών είναι κάτι που παρακολουθώ στενά καθώς είναι άμεσα συνδεδεμένο με τις επιπτώσεις του προγράμματος προσαρμογής πάνω στην Ελληνική οικονομία θα ήθελα να γράψω δύο λόγια για την μελέτη (τα οποία θα είναι περισσότερα τεχνικά από ότι συνήθως).

Η μελέτη πραγματοποιεί μία οικονομετρική εκτίμηση των δημοσιονομικών πολλαπλασιαστών δαπανών και φόρων (συνολικά αλλά και ανά ευρεία κατηγορία δαπανών/φόρων) με βάση ένα structural VAR μοντέλο. Προκειμένου να εκτιμήσει τους πολλαπλασιαστές στη διάρκεια της ύφεσης και αν αυτοί είναι διαφορετικοί από το συνολικό δείγμα (1999 με 2013) προσθέτει και ένα dummy variable από το 2008Q2 και μετά. Στο άρθρο παρουσιάζονται οι ‘αθροιστικοί δημοσιονομικοί πολλαπλασιαστές’ (accumulated impulse responses) για τις δύο εκτιμήσεις:

KEPE - Greek Fiscal Multipliers

Όπως είναι φανερό, με βάση την εκτίμηση του ΚΕΠΕ, οι πολλαπλασιαστές της δημόσιας κατανάλωσης είναι αρνητικοί ενώ μόνο η δημόσια επένδυση είναι υψηλότερη από την μονάδα. Ο πολλαπλασιαστής των άμεσων φόρων είναι αρνητικός και ίσος περίπου με -2 ενώ και των έμμεσων φόρων σημαντικά υψηλός και ίσος με -0,8. Η εξήγηση που δίνεται έχει να κάνει κυρίως με την υψηλή ροπή για εισαγωγές της οικονομίας η οποία συνεπάγεται το leakage των δαπανών προς το εξωτερικό ενώ η στρεβλωτική επίδραση των άμεσων φόρων είναι σημαντική. Το προφανές συμπέρασμα είναι ότι το μείγμα της προσαρμογής θα πρέπει να είναι προσανατολισμένο στην μείωση της δημόσιας κατανάλωσης, στη στήριξη των επενδύσεων και την μείωση των στρεβλωτικών άμεσων φόρων.

Πάμε τώρα στην κριτική. Κατ’ αρχήν από πλευράς παρουσίασης η μελέτη είναι το λιγότερο εξαιρετικά ελλιπής. Το μόνο που παρουσιάζεται είναι ο πίνακας των impulse responses και ακόμα και αυτός χωρίς confidence intervals. Η ακριβής μορφή του VAR estimation με τις τιμές και τα standard errors των coefficients όπως και τα στατιστικά για τη συνολική εκτίμηση (R², information criteria κτλ) ή στοιχεία για το stationarity των μεταβλητών που χρησιμοποιούνται απλά δεν υπάρχουν πουθενά. Ο αναγνώστης καλείται να πιστέψει το συγγραφέα ότι η εκτίμηση έγινε με τον καλύτερο δυνατό τρόπο.

Από εκεί και πέρα θεωρώ ότι το specification που ακολουθήθηκε είναι λανθασμένο. Η υπόθεση ότι οι πολλαπλασιαστές είναι διαφορετικοί στο expansion από ότι στο recession συνεπάγεται ότι το μοντέλο πρέπει να προβλέπει διαφορετικά coefficients ανά regime, κάτι το οποίο γίνεται με TAR/STAR σε AR μοντέλα και TVAR/STVAR σε VAR υποδείγματα. Το ‘state of the art’ μοντέλο είναι το (Auerbach & Gorodnichenko, 2012) το οποίο και πρότεινε αρχικά το STVAR μοντέλο. Αυτό έχει χρησιμοποιηθεί σε μία σειρά από ερευνητικές εργασίες τόσο του ΔΝΤ (για το G-7 και άλλες περιπτώσεις), όσο και της Eurobank η οποία υπολόγισε τους δημοσιονομικούς πολλαπλασιαστές στην Ελληνική περίπτωση. Η εκτίμηση της είναι πολύ διαφορετική από του ΚΕΠΕ καθώς ο πολλαπλασιαστής δαπανών βρέθηκε ίσος με -1,42 στα expansions (και μη στατιστικά σημαντικός) και 1,32 στο recession (και στατιστικά σημαντικός).

Μιας και σε πολλές περιπτώσεις ένα VAR μοντέλο δε διαφέρει από μία σειρά απλών AR specifications τα οποία εκτιμώνται με OLS ας προσπαθήσω να εξηγήσω απλά ποιο είναι το misspecification του ΚΕΠΕ. Γενικά μία από τις βασικές παραδοχές στην εκτίμηση οικονομετρικών μοντέλων είναι η σταθερότητα των συντελεστών. Αν αυτοί δεν είναι σταθεροί αλλά το slope αλλάζει ανά regime τότε πρέπει να βρούμε τρόπο να εισάγουμε κάτι τέτοιο στο μοντέλο, διαφορετικά ουσιαστικά θα εκτιμούμε ένα weighted average διαφορετικών coefficients (που θα εξαρτάται από τη συμμετοχή του κάθε regime στα δεδομένα μας). Σε ένα plain vanilla AR(1) μοντέλο ένας απλός τρόπος είναι να εκτιμήσουμε ένα Threshold AR specification όπου ένα dummy θα καθορίζει το regime στο οποίο βρισκόμαστε. Δηλαδή:

ScreenHunter_08 Jan. 24 11.42

Πιο ‘εξελιγμένα’ μοντέλα επιτρέπουν την ομαλή, συνεχή μετάβαση μεταξύ των regime, κάτι το οποίο κάνει το STAR/STVAR αλλά με κόστος την πολύ μεγαλύτερη περιπλοκότητα και δυσκολία στην εκτίμηση (ενώ αν οι μεταβάσεις είναι σύντομες η προσέγγιση με TAR δεν είναι προβληματική). Το ΚΕΠΕ, εισάγοντας ένα dummy variable για τον καιρό της κρίσης αυτό το οποίο εκτίμησε ήταν:

ScreenHunter_09 Jan. 24 11.42

Ουσιαστικά δηλαδή θεωρεί ότι ο slope coefficient μένει σταθερός και αυτό το οποίο αλλάζει είναι το conditional mean. Αν μάλιστα το φ2 αλλάζει στο specification με το dummy (που δεν είναι παράλογο με δεδομένα τα αποτελέσματα της Eurobank) τότε ουσιαστικά ένα impulse response θα παρουσιάζει το ‘μέσο όρο’ αυτών των δύο μεταβλητών και οι προβλέψεις δε θα είναι κοντά στην πραγματικότητα. Προφανώς τα δύο μοντέλα είναι εντελώς διαφορετικά μεταξύ τους και η εκτίμηση που θα δώσουν για την επίδραση shocks θα είναι επίσης διαφορετική. Δεν είναι περίεργο λοιπόν που οι προβλέψεις του μοντέλου του ΚΕΠΕ έχουν πολύ μεγάλη απόσταση από αυτές της Eurobank. Σαφώς θα ήθελα να μπορώ να δω τις λεπτομέρειες της εκτίμησης που έκανε ο συγγραφέας αλλά με τα διαθέσιμα δεδομένα δε θεωρώ ότι τα αποτελέσματα της μελέτης είναι συνεπή.

This will be a quick follow-up post on the 2014Q3 employment figures post. The Greek Ministry of Employment publishes monthly figures of employment announcements by employers on an online registration system called ‘Ergani’. Based on the recently announced numbers for December of 2014 (sorry the document is in Greek) I ‘d like to make a few projections on the current state of unemployment in Greece:

Greece Net Employment figures 2014H2 - Ergani

It is quite evident that net employment flows were negative during 2014H2 due to 2014Q4 dynamics (which are not yet reflected on the unemployment survey numbers published by ELSTAT). Compared to 2013 the total difference was 120,000 jobs (from a positive net flow of 43,000 jobs to an outflow of 77,000 employees) with the fourth quarter loosing almost 90,000 jobs, a figure close to three times that of 2013.

Since seasonal adjustment of employment is always a smoothing mechanism which requires a large number of observations my feeling is that October/November monthly employment surveys, as well as the quarterly 2014Q4 survey, will register a significant fall in employment which might result into an increase of the unemployment rate. With a labour force of 4,830 thousand people, the 88,000 jobs shortfall during 2014Q4 is equal to almost 2% which should appear in the unemployment numbers during the upcoming months. Something to definitely keep an eye on.

So it seems that a European QE program is highly probable although Greek government debt is at risk of not being included since it is not rated investment grade and the ECB will only include it in the list of assets purchased if Greece remains in a refinancing program.

In this short post I ‘d like to note a few things on the magnitude of the impact that such a program would have on Greek bonds. Based on the Greek ECB capital key (2%) and the anticipated QE size (which most analysts put around €500bn), the ECB might end up buying around €10bn of Greek debt securities. PSI related bonds principal is now around €29.6bn while long-term bonds issued by the Greek government during 2014 totaled another €6.9bn. Bonds with a residual maturity of up to 10 years are only €12,2bn which, given current market prices, are worth much less than €10bn.

Greek bonds till 2029

As a result, ECB will ultimately be making a bid for all the outstanding market value of long-term Greek bonds (with a residual maturity of up to 10 years), increasing liquidity in the bond market considerably (and making it the largest holder of Greek debt). That will obviously drive current market prices much higher and also allow the Greek government to immediately return to the market since bidders will have a (free) put option of selling most of their holdings to the ECB. As long as the upcoming QE is pari passu with private bondholders (as is the OMT program) and the Greek government establishes a credit line program (which creates another put option for bondholders) the (QE) program will allow an orderly return of the Greek government to private bond markets.

Since the Greek debt maturity profile suggests that only mostly 2015 and 2019 are years that involve large debt refinancing needs (which lowers any default risk post 2015) a QE program will have long-lasting stabilization effects. These effects will be even higher if ECB profits from the program are returned to the corresponding Treasuries (which I suspect will happen if eventually the program involves each NCB buying its own government debt securities).

nov14 Greek debt maturity profile en

Personally I would also like to see a second buyback of Greek debt to take advantage of low market prices and also to lower the nominal value of post-PSI bonds which, due to the EFSF co-financing scheme, are senior to newer bonds issued by the Greek government (a fact that can create difficulties for Greece issuing bonds that have similar maturity dates as outstanding PSI bonds). A possible buyback could be combined with an exchange offer to consolidate the current series (which stretch a 20 year period with low nominal values per bond of less than €1.5bn) into two or three securities that will be of much larger nominal value and liquidity and thus improve market making and secondary market trading.

I ‘ve been bogged down with my PhD courses lately and this blog has not seen the share of posts that it was accustomed to. In any case, since I ‘m looking back into our Macro 1 course (which is based mainly on the Romer and Blanchard books, both quite informative and good to have) I ‘d like to touch on the math of the Ricardian Equivalence and the Government Budget Constraint.

As is well known, the Ricardian Equivalence (RE) states that only the quantity of government purchases, not the division of the financing of those purchases between taxes and bonds, affects the economy. This is based on the household budget constraint of a Ramsey model where the government budget constraint (with equality) is applied. What the latter suggests is that the government must run primary surpluses large enough in present value to offset its initial debt.

Usually the government budget constraint is taken at face value by most economists while Ricardian Equivalence is suggested that it might not be (completely) valid in practice due to facts such as short-term horizons, liquidity constraints, different interest rates faced by the government and households and the Zero Level Bound. Nevertheless, I ‘m not so sure that a lot of people would disagree with the RE model in its original form (a very nice reference for both issues is chapter 12 of Romer).

In this post I would like to support the proposition that mathematically both the RE and the government budget constraint require the assumption that, at the infinite horizon limit, private household net financial wealth is zero. Households only gain utility from consumption so, at the limit, they will consume all financial wealth they hold which suggests that the present value of government primary surpluses should be equal to government debt.

Obviously this only works in a world where money is neutral and ultimately is only used as a transactions medium and not as a store of value to hedge an uncertain future. The notion of «safe assets» does not really enter into the realm of the Ramsey model where the representative agent either has perfect foresight or faces stochastic risk (and not genuine uncertainty).

As Philip Arestis elegantly states, «all economic agents with their rational expectations are perfectly creditworthy. All IOUs in the economy can, and would, be accepted in exchange. There is thus not need for a specific monetary asset. All fixed-interest financial assets are identical so that there is a single rate of interest in any period.»

Once this assumption is relaxed and the private sector requires a safe store of value not only to facilitate wealth maintenance but even the daily flow of transactions (with government debt securities playing a crucial role in monetary policy operations and the repo markets), the government budget constraint breaks down while an increase in the supply of government debt can even be stabilizing (see for example the relevant Treasury programs during the 2008 credit crisis) and is required in order for the private sector to maintain its wealth in a safe store of value, free from shocks that might emerge in an uncertain world.

Further, mathematical details can be found in the attached (small) pdf document.

Government Budget Constraint – Ricardian Equivalence


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