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The recent narrative regarding Greek debt sustainability has moved from the debt-to-GDP ratio towards the annual debt financing costs (interest payments + maturing debt). According to this analysis, Greece already enjoys very generous terms until 2020 and beyond and will only require small debt reprofiling measures in terms of interest rate payments and debt maturities after 2022. What is needed according to its creditors is for Greece to continue on the reform path, achieve economic growth and commit to credible fiscal measures that will allow it to maintain high primary surpluses close to 3.5% of GDP. Unfortunately that can only be achieved through tough measures on the pension front. «As long as Greece continues on this path, creditors will do their part» as the story goes.
In my view the above story is problematic, mainly because it relies on Greece achieving and maintaining a 3.5% GDP surplus target, a target which I believe is not credible in the long-run. In order to examine the subject from a theoretical point of view, I will use some well known concepts in economics, debt overhang and dynamic inconsistency.
Debt overhang is a concept usually used in corporate finance. It is based on the idea that, as long as the corporate balance sheet carries too much debt (which always takes precedence in payment over stock), stockholders do not have an incentive to contribute new funds in order to fund new investment projects if the proceeds are mainly used to improve the recovery rate of creditors. Balance can only be achieved if creditors ‘share the costs’ through a restructuring of the liability structure of the company balance sheet.
The same applies in the case of Greece. Its own ‘stakeholders’ do not have an incentive to contribute funds (in the form of high taxes or lower pensions/wages) if the increased surpluses will mainly be used to improve and ‘guarantee’ the recovery rate of foreign creditors. Given that Greece has a negative external balance (especially the cyclically-adjusted figure) it is an accounting fact that a primary surplus will involve a deterioration of the Greek private sector net financial assets position. Maintaining a 3.5% surplus target in the indefinite future involves a very large transfer of financial wealth from the Greek private sector to foreign official creditors with only a small part of the (possible) growth dividend staying in Greece. Most corporations would not accept such a bargain unless under threat, something which is more than evident in the Greek case where the Grexit threat has been thrown around for more than 5 years now.
Dynamic inconsistency on the other hand involves the idea that sometimes the solution to a dynamic optimization problem depends on the specific time when the problem is evaluated, which has the effect that a specific action time path is not credible.
A classical example is capital taxes. A fiscal authority might want to commit to low capital taxes in order to achieve large investment and growth. Yet at time t=1 investment has already been made and the temptation is high to increase capital taxes in order to enlarge fiscal revenue.
In a way, the same applies in Greece. In order to achieve debt sustainability, the fiscal authority must commit to a path of large primary surpluses. Yet, given the fact that such surpluses deteriorate the private sector position and the possibility of a negative shock hitting the economy, it is highly likely that Greece will have to lower its surplus (or even run a deficit) at some point in time. When the time of a negative shock comes, the optimal solution for the sovereign is to try and smooth the effects of the shock on the economy, not maintain a target that will only make matters worse.
As a result, especially given the need to maintain the surpluses for a very long time (in order to achieve debt sustainability), such a path is not credible. The fiscal authority will deviate ‘at the first sign of trouble’.
Combining the debt overhang with the dynamic inconsistency argument leads to a clearly unstable equilibrium. Both the sovereign and the Greek private sector (Greek stakeholders) do not have the incentive to commit on a high surplus strategy. Under completely rational behavior they have every reason to not damage their financial position and maintain the best possible growth rate. Any commitment on the high surplus strategy will not be credible but only a ‘temporary deviation’ in order to avoid short-term negative outcomes since the Grexit threat is still considered credible.
In my view, only a path of low future surpluses (accompanied by a large upfront debt restructuring) is a long-term credible strategy. Otherwise, we ‘ll keep on observing the current ‘stop and go’ path, with the Greek government implementing the least possible measures and its creditors using Grexit as stick and the (insufficient) future debt reprofiling as carrot in a repeated game with a non-optimal outcome.
Recently we had to write a large essay on the bank loan pricing procedure of the banking system under imperfect competition (for the banking course we ‘re currently attending). The end result was quite interesting and we have posted it as a Working Paper on ssrn. The paper is heavily based on the relevant work of Ruthenberg and Landskroner (2008) which has been extended with more realistic assumptions such as a non-zero Recovery Rate on loans and a securities portfolio to match capital and reserves.
The paper first describes a few stylized facts of modern banking with sections on modern monetary policy implementation and the actual interbank market (where monetary policy acts as an interest rate cap on ‘competitive spreads’). This is followed by a general (stochastic) model for the term and credit risk premium added on loan rates.
The model assumes that a bank finances a new loan by borrowing in the interbank market under Cournot oligopoly and Basel capital requirements. We only examine the case of a properly functioning interbank market with very low excess reserves and liquidity hoarding. The end result is the following equation:
where RL is the loan rate, Ps the borrower’s probability of survival, Rf the risk-free rate, θ the spread in the interbank market over the risk-free rate, k cost of equity (RoE), H the Herfindhal-Hirschman index of concentration in the loan market, ε the elasticity of demand in terms of RL for new loans by bank customers and φ is the risk premium per borrower which is equal to:
φ = PD x LGD
(PD: Probability of default or 1-Ps and LGD: Loss-Given-Default).
Based on the above equation, it is clear that the main drivers of the loan rate are the Probability of Default and the risk-free rate (these two factors account for over 90% of the loan rate). PD enters the equation both as a ‘compounding factor’ and in the risk premium φ. The end result is that for PD higher than 5% the compounding factor increases substantially and a loan becomes very expensive. The obvious conclusion is that the PD is used as a ‘first line of defence’ by banks in order to determine if a loan will be offered in the first place and the amount made available (especially as a percentage of available collateral, proxied by the Loan-to-Value ratio).
This explains why credit crises and large recessions lead to a ‘credit crunch’ since a large enough PD will result in loan rejections and not in a (very large) increase of the offered loan rate. Updates to a borrower’s PD /LGD (after a loan has been extended) are usually large enough that a bank cannot include them in the loan rate risk premium (without pushing a borrower to an early default) and are incorporated in Loan-Loss provisions.
Under perfect competition (H close to zero) banks are not able to earn a premium over the risk-free rate (apart from the borrower risk premium) and only get their required RoE. If market power exists banks are capable of gaining an above normal profit which is rather marginal for H lower than 0.1 (usually lower than 10% of the risk-free rate). For large enough HHI the premium becomes quite significant.
Both the RoE and Basel capital requirements play a role in the loan rate offered although that depends mainly on the loan’s risk weight.
The model specification was followed by a simple application in the Greek banking system during the Euro era (and before the 2007-2008 credit crisis). Although we did not use any econometric techniques in this essay, the model performed quite well with an R² of 0.93. Given the current HHI of 0.214 it seems that banks have gained (through M & As) significant market power and are able to impose a premium of close to 30% over the risk-free rate in their quoted loan rates (based on the model’s projections).
Our next step is to use the model in order to look into the Greek banking system with more detail and estimate an econometric specification. Still, the basic stylized facts that can be drawn are quite significant and can explain why credit crises lead to a credit crunch and how higher probabilities of default eat into bank profits through loan-loss provisions. Obviously we would appreciate any comments on the paper and the outlined model.
I find studies of income inequality and economic growth especially interesting since, apart from anything else, they highlight the differences between the neo-classical consensus and the post-keynesian view of the world. In this context I found two papers by Simon Mohun published on the Cambridge Journal of Economics and focusing on income inequality due to supervisory wages growth and on capital productivity long-term movements very enlightening. The fact that the author uses simple accounting exercises instead of relying on heavy econometric work is also quite positive since it keeps the analysis simple and not easily questionable.
The author starts by looking at the evolution of the US profit share (defined as profits to the capital stock) since the early ’60s. The rate is decomposed in the profit share (profits to value added) and capital productivity (value added to the capital stock) using a simple chain rule:
What the author then does is to decompose the economy into ‘productive’ and un-productive sectors and the workers into supervisory and non-supervisory employees. It turns out that supervisory workers saw a large increase in their wage share especially after 1980 while non-supervisory workers experienced a large fall in their own share after a mild increase in the 1964-1979 period:
If one expands the ‘capitalist class’ to also include supervisory workers which means that their wages should be included in the profit share, the actual path of the profit share turns out to be quite different than the original series:
As a result, the ‘expanded’ profit rate actually shows a significant increase after 1980 with a large part attributed to the expansion of supervisory wages and not only to the increase of capital productivity:
What should be stressed at this point though is that this expanded profit rate does not provide the financing means for an expansion in investment (which would be naively assumed to be the driver of the increase in capital productivity) but rather is appropriated by the supervisor ‘worker’ class.
In the second paper, Mohun takes a deeper look at capital productivity as well. Keeping with the productive/un-productive distinction, the capital productivity growth is decomposed into:
- the expansion of the productive and un-productive fixed assets (which tend to explain a small part of the growth)
- relative prices (between capital goods and general output) and
- the ratio of labor productivity to capital deepening (the ratio of the capital stock to labor hours).
The findings on relative prices are in agreement with other studies on the subject which find that capital goods ‘got cheaper’ since 1980 and were a significant driver of the divergence between labor productivity and real wages. The author finds that during 1982-1998 relative prices contributed around 35% to the change in capital productivity:
The major driver though was the large change in capital intensity. While capital deepening (it is named technical composition of capital in the paper) grew close to 3% in the 1966-1982 period, it stagnated (-0.1%) in the 1982-99 period. Labor productivity growth remained roughly the same at 1.5% and 1.4% respectively.
So it seems that firms not only took advantage of lower capital goods inflation in order to increase their capital productivity but were actually able to maintain growth in labor productivity without investing into productive capacity (at least in relative terms). The paper speculates that this growth was achieved through the introduction of more efficient ‘management and organization techniques’.
In any case, the papers make it quite clear that the deepening income inequality since 1980 was driven primarily by the rise of the manager class whose renumeration grew at the expense of productive workers and normal profits. This growth was made possible by the lower relative fixed assets inflation and continued increases in labor productivity despite a complete reversal in capital intensity by corporations.
The above is also reflected in a more detailed study of income growth in the top income earners based on US tax return data:
Table 7 shows that the share of national income (excluding capital gains) received by the top 0.1 percent of income recipients increased from 2.8 percent in 1979 to 7.3 percent in 2005. Again, the shares received by executives, managers, supervisors, and financial professionals increased markedly, with the increase in the share of income among these occupations accounting for 70 percent of the increase in the share of national income going to the top 0.1 percent of the income distribution between 1979 and 2005. The pattern is similar in Table 7a when we include capital gains.
One recurring statement (usually related with the Euro-Drachma debate) is that the type of currency does not play a role, only the ability to efficiently produce competitive products and the presence of a modern institutional and organizational setting.
This type of reasoning is actually very similar to the ‘New Consensus’ (NC) macroeconomic view. The economy follows a supply-side driven natural growth path, subject to stochastic exogenous shocks which move the economy’s output gap far from zero and create inflationary (or disinflationary pressures). In a New Keynesian model, price and wage rigidities allow the central bank to change the short-term real rate (by changing the short-term nominal rate) which results in a deviation from the natural equilibrium (Wicksellian) rate of interest. This deviation eventually clears the output gap and returns the economy to its predetermined expansion path. The model as a whole contains the neutrality of money property, with inflation determined by monetary policy (that is the rate of interest), and equilibrium values of real variables independent of the money supply. The final characteristic is that the stock of money has no role in the model; it is merely a “residual.”
In essence, the NC world view can be summarized in the words of King (1997):
if one believes that, in the long-run, there is no trade-off between inflation and output then there is no point in using monetary policy to target output. …. [You only have to adhere to] the view that printing money cannot raise long-run productivity growth, in order to believe that inflation rather than output is the only sensible objective of monetary policy in the long-run” (p. 6)
The Keynesian view is quite different and stresses the fact that in reality the economy expansion path is not predetermined by supply-side factors, nor is money neutral. On the contrary:
- Liquidity preference (see Arestis 2003) is an important issue. Financial assets are not close substitutes nor is credit risk negligible. As a result, relative prices and credit spreads play a decisive role since they determine the net worth of economic players (especially banks) and credit availability. Even the mere ‘creation of money’ by the central bank can have expansionary effects if it is targeted on specific, temporarily illiquid assets (with QE1 targeted on MBS being a strong example) since it expands the supply of ‘safe assets’.
- Growth is to a large part endogenous while hysterisis effects are significant. The natural rate of growth is driven by demand growth (Thirlwall 1998) which generates hysterisis effects and path-dependence for the economy (Lavoie 2003). The NAIRU (if it exists at all) is closely related to the capital stock (since the elasticity of factor substitution is less than unitary) which suggests that effective demand and its effect on net investment strongly influences long-term employment (Arestis 2007).
- Economic decisions are governed by genuine uncertainty and not by a known probability distribution, something evident especially in the case of long-term investment projects. Savings equal Investment only ex post and do not ‘drive’ expansion. That would require that while savers increase their preference for liquid assets, investors are more willing to part with liquidity, increase their leverage and hold actual illiquid assets (in the form of fixed investment and higher inventories), which is actually only possible if future profitability is increased and spare capacity is no longer available.
Even in the neoclassical tradition, post-2008 thinking acknowledges that monetary policy can have significant short and long-term effects on growth:
- Long-term rates (which are relevant for investment) are not always closely linked to short-term money market rates, especially in stressed market environments. The central bank therefore needs to use balance sheet policies apart from setting the short-term rate in order to move long-term rate expectations.
- The natural rate of interest is not known with any significant confidence level and is contingent on economic conditions, preferences and expectations (Federal Reserve 2001).
- Disinflation (and even worse deflation) starting from already low inflation levels has strong effects on economic growth, since the output-inflation rate tradeoff is non linear (IMF 1998, Fed 1998), something which is highly relevant in the Greek case.
Furthermore, since the ECB target is of close to 2% annual inflation, strong deflationary expectations (which are now present in Greece) can only be considered a failure of its monetary policy. As long as the ECB does not act to correct this problem, it would be hard to suggest that monetary policy does not play a decisive role in the current Greek predicament.
Lastly, in cases of large real exchange rate devaluations (which is the stated target of the Greek adjustment program) the method of devaluation certainly plays a major role. Internal devaluations are usually followed by debt deflation effects with large output and employment losses and significant increases in non-performing loans and the (private and sovereign) debt burden (which is not deflated as are prices and income). External devaluations on the other mostly hurt the external sector claims while resulting in significant changes of the real exchange rate.
The Greek Labor Union (GSEE) will announce shortly an econometric study stating that employment in Greece will not return to its pre-crisis levels for at least a decade, even if Greece achieves an annual real GDP growth rate of 3.5%. In this post I ‘d like to perform some basic back-of-the-envelope calculations to confirm the above statement.
Let’s assume a Cobb-Douglas production function:
In Greece, the labor share (wage share) has been rather constant at around 54% while the long-run average for Total Factor Productivity (TFP) has been 1.5% (for a technical yet very detailed examination of the production function components in the context of potential output calculation one can look at this paper from the EC). Assuming a 3.5% real GDP growth rate, a constant TFP growth of 1.5% annually and also that capital and labor maintain their shares (which roughly means that they will have equal growth rates), then the growth in employment will be:
dL = (dY – dTFP) / 2 or close to 1%.
The labor input in the production function is measured in hours worked. The long-run average was more than 2100 hours/year while in 2012 the corresponding figure was 2034. The necessary increase to reach the long-run mean is 3.2%, which means that, at least during the first 3 years, employment growth will be minimal. Based on Ameco data, current employment (in persons) is close to 4000 thousands (compared to more than 4600 in 2008) which means that a 1% will translate to roughly 40,000 persons finding a job (after hours worked have returned close to 2100 per year).
It is clear that some basic accounting confirms the labor union findings. The first 5 years of GDP growth will witness only minimal gains in employment (roughly close to 100,000 persons) while at the end of the 10-year period employment will still be less than 2008 figures. Actual unemployment statistics might change more favorably due to a lower 16-64 population, participation rate changes and net migration.
Since the usual narrative about the Greek economy after the Euro introduction involves a large movement of resources and employment towards the non-tradable sector, it is interesting to check this claim against available data. I will be using the Ameco database and looking into the sectoral contributions on total Gross Value Added and Employment between 1995 and 2008 (in order to account for pre-Euro effects and not pollute the statistics with the post-2008 crisis).
Services GVA contribution did increase steadily from 71% during the mid-1990s to 78% in 2008. Nevertheless, excluding 2008 (which included a large fall in the industry contribution), almost all of the fall is attributed to lower agriculture GVA contribution (from 7.4% in 1995 to 3.5% in 2007, a fall of 4%). Industry only fell from 14% in 1995 to 12% in 2007. Although industry certainly lost ground (and was much lower than the Euro average of 20%), it seems that most of the change in GVA contributions is due to the Greek economy transitioning to a more ‘mature’ form with agriculture moving closer to the Euro area average of 2%. On the other hand, services contribution increased from 71% to 76% (in 2007), moving higher than the long-run Euro average of 71% (which was quite steady during the same period). Building and construction certainly do not show any signs of a bubble, except for a short period of time during 2006-2007.
The above observations are even more evident in the employment front. Industry shows a small drop in employment contribution (from 13.5% to 11.6%) which could be attributed to higher productivity while agriculture is the main sector losing employment, with its share falling from 19.3% to 11%. The primary source of employment growth is the services sector which increases from 60.5% to 69% during the same period.
Overall, although the long-run industry contributions are far lower than the Euro average, the Greek economy rebalancing during the Euro era is a result of its GVA composition ‘maturing’, with agriculture moving closer to European averages and the relevant resources and employment being absorbed by the services sector. Compared to the Euro averages (20% industry, 71% services), it is true that the movement went on the ‘opposite direction’, with the services sector growing to the disadvantage of industry (12% industry, 76% services), probably as a result of easy credit conditions.
Looking at more detailed data from the Greek statistical agency, land and water transport services contributions increased from 4% in 2000 to almost 7% in 2008 while ‘Accommodation and food and beverage service activities’ fell from 7.4% to 5.6%. As a result, the data are rather mixed about if the increase in the services sector contribution came from tradable or non-tradable parts. It seems that a large part of the 5% change (but certainly not all) can be attributed to non tradables.
Taking the above at face value, around 3-4% of GVA (and a corresponding part of employment which is equal to around 200,000 persons) should have moved to the tradable sector since 2008. The rough size of this ‘overshooting’ certainly cannot account for the enormous loss of output and employment since 2008 which can only be attributed to the negative credit conditions and fiscal austerity. The price paid for a relatively small adjustment is quite high.
Since i ‘ve recently had a couple of university professors analyze the expectations augmented Phillips curve, I ‘d like to do a short analysis of the relationship, especially in the context of inflation targeting by central banks. First, it is important to point out that the original Phillips equation reflected a relationship between wage growth and unemployment. The modern Phillips curve assumes constant real wages in order to substitute wage inflation for the inflation rate and come up with:
π = π* – ε(u – u*) where π* is the expected inflation rate and u* is the natural rate of unemployment.
This assumption shows its weakness if one uses another route to come up with a breakdown of inflationary sources. Using the equation of exchange:
PQ = PY (Q: real output, Y: real income)
and noting that income is distributed between wages and profits we can come up with:
PQ = (W + U)
Multiplying and dividing by W:
PQ = (W + U/W) * W
W + U/W is actually the aggregate mark-up of profits to wages, which can be set to m:
PQ = mW
Dividing both parts by L (employment):
P*(Q/L) = m*(W/L)
and renaming Q/L to average labor productivity (APL) and W/L to the money wage and taking natural logs we end up with:
π = m + w – APL
In other words, inflation is created by the excess increase of wages and markups to the growth of productivity. Given that the original Phillips curve focused on wage inflation, we can substitute w with the expectations augmented equation to reach:
π = m + (π* – ε(u – u*)) – APL
and moving inflation expectations to the left:
π – π* = m – APL – ε(u – u*)
Modern central banks follow inflation targeting with a view of minimizing the output gap. Taking that policy as given and assuming it is successful at anchoring actual inflation to the expected it is clear that:
m – APL = ε(u – u*)
As a result, only if the markup growth rate is equal to the increase of labor productivity will the outcome be unemployment close to the natural rate while workers will enjoy constant real wages. If firms manage to increase their markups more than productivity they will be able to earn a larger share of income while leading the economy to an unemployment gap. The increased unemployment will lower labor bargaining power and its ability to achieve wage increases. Consequently, pure inflation targeting will not necessarily lead to an optimal outcome but can allow ‘capitalists’ (used with the classical definition of owners of the means of production) to secure higher shares of income while lowering the labor force negotiating power and increasing the unemployment gap. Coupled with a financial sector willing to provide easy credit, this policy can have long-term redistributional effects.
* The original discussion appeared on heteconomist.
Continuing on the path of the series on the Greek macro crisis I will focus on gross capital formation during the Euro era in more detail, especially in connection with imports of goods. First, let’s start with a breakdown of investment in main sectors since 1990 (as %GDP and not including inventory changes):
It is quite evident that dwellings are the principal component of investment, especially during the early times of the 1990’s. This component displayed a large drop in the early 1990’s from 16% to 10% GDP where it settled for the greatest part of the following years with small changes. Only during a very short period in 2006 – 2007 did it climb momentarily to 12.5% GDP. So it seems that no housing investment boom actually happened in Greece after the Euro, although house prices did appreciate significantly. The rest of the investment components show quite steady figures. Transport equipment (which includes shipping) displays significant fluctuations while equipment was stable around 4% of GDP with the exception of 2007 – 2008 when it increased to 4.5 and 5%.
Looking into the figures since 2008 makes the depth of the depression very clear. Dwellings construction dropped from 12.5% in 2008 to 4.7% in 2011 and is projected to reach 4.3% in 2012. Equipment investment went from 5% in 2008 to 3.2% in 2011 and other buildings and structures (which include public works) from 4.6% in 2009 to 3.2% in 2011.
Overall, the deepest drop has been in dwellings, a loss reflected in construction employment as well which has lost more than 170,000 workers (from around 400,000 in 2007). This figure alone accounts for a loss of 8.2% in GDP, more than half the cumulative 2009 – 2011 drop. Most of the components have now settled to such low figures that just basic capital stock maintenance will allow for these levels to be preserved. As a result, investment (and output in the aggregate) will stabilize mainly due to the ‘zero level bound’.
Relation with imports
What I ‘m interested in this post is how investment components relate to imports of goods. For this reason I will use Bank of Greece balance of payments data to construct imports of goods excluding fuels and ships (as %GDP). Since data availability is thin, only the 2003 – 2011 period will be examined.
Since these are time series data, the first action is to determine which are stationary through Dickey-Fuller unit root tests:
* I(0) stand for stationary and I(1) for stationary by taking first differences.
As it turns out, the components are not stationary. Transport equipment was not included since imports do not include ships. Trying to determine a suitable regression relationship leads to the observation that most of the components do not appear to be highly significant. One simple yet robust relationship is the following:
* denote 90% confidence interval, ** 95% and *** 99%.
Changes in Equipment and dwellings investment during the previous year are able to explain a large part of the current year change in imports. Both coefficients are large, while the equipment one is also negative, meaning that an increase in equipment investment during one year will lead to a drop in imports during the following one.
Based on the above coefficients we can examine the exact magnitude of the effect changes in investment (in these two sectors) had on imports during 2008 – 2011 (including 2008):
The total effect was very close to the actual change and explains almost 90% of the total change with dwellings playing a key role. Assuming the Greek economy returns to growth and the above relationship is linear on the upturn as well, going back to long-term figures of 10% for dwellings and 4% for equipment will lead to an increase of imports equal to 2.8% GDP or close to 3/5 the total drop during 2008 – 2011. A recovery will need to be much more focused on equipment investment (and manufacturing in general) rather than constuction (with the corresponding structural effects on employment) for imports not to increase as much.
I recently came across an interesting paper (from the author of slackwire) on Fisher Debt dynamics of private debt. The basic idea is that, just like public debt dynamics calculations, private liabilities as percentage of income are not only the outcome of savings but a more complicated function of the primary balance (net borrowing – interest payments), income growth, inflation and interest payments. Changes in these factors, limits such as an inflation target or the zero level bound on interest rates play a significant role on the long-term path of the private debt burden (liabilities to income), in this case household liabilities.
The authors used flow of funds data for the US in order to examine these factors more extensively. An initial finding is the fact that savings data cannot be used to gauge on the primary balance. Since savings can be defined as ‘savings = primary surplus + tangible investment + net acquisition of financial assets – interest payments’, debt related factors play a central role, something which is evident in the following graph:
In order to examine debt dynamics the law of motion of government debt is used for private liabilities:
in a reduced linear form:
d is the primary deficit to disposable income (net borrowing – interest payments), i the effective interest rate (interest payments / debt of previous year), growth is the nominal growth in disposable income, π the inflation rate and b private liabilities of the previous year / disposable income. Using this (almost accounting) equation, the contributions of each components can be examined for a period starting during the Great Depression:
*pi is inflation rate
The relevant conclusions are:
- The Volcker shock is quite evident in the data, with the effective interest rate contribution remaining very high ever since 1980.
- The 70’s inflation shock was actually instrumental in managing to keep the debt growth in mostly negative territory.
- Households actually moved to a primary surplus during most of 1980 – late 1990’s. Positive debt movements were the result of high effective interest rates and the disinflation project since 1980.
- The unsustainable increase in primary deficit during the 2000 – 2007 is very clear. The magnitude of the sustained deficit (the integral in mathematical terms) is almost unprecedented in the data.
- The tremendous shift of almost 15% in the primary balance after 2007 is impressive. Nevertheless, interest rate and income growth dynamics made the actual debt decrease much lower.
A counterfactual scenario is examined were the primary deficits remain the same as the actual data, but growth, interest and inflation rates are the same as the 1945 – 1980 period. This results in a a totally different debt path, which shows that since 1980 the debt path was mainly driven by ‘Fisher dynamics’ and not profligate households:
The obvious exercise is to perform a corresponding examination of Greek household data. Unfortunately, flow of funds data such as interest payments are not that easy to find, while a reclassification of loan data happened during 2010 which breaks the debt series somewhat. I ‘ve used Bank of Greece data on interest rates and loan amounts in order to proxy the effective interest rate. During 2006 – 2009 households incurred loan liabilities to the RoW, most probably a result of loans in foreign currencies (such as swiss franc) so I do not consider the effective interest rate calculation absolutely accurate. Still, the calculated change is very close to the actual one of debt to income. Due to data availability, only the 2003 – 2009 period will be examined:
The interplay between the relevant factors is more evident in the following graph:
The household primary deficit was very large during the 2003 – 2007 period, around 8 – 9% of income, while income growth was much lower, driving a debt financed consumption. Tight ECB inflation policy meant that inflation was not a significant balancing factor, while the large increase in debt made the effective interest rate contribution larger, even though the nominal interest rate was on a downward trajectory.
Since 2008, the primary deficit moved to surplus (a change of almost 9% of income) Nevertheless, debt change was still positive (5% in 2008 and 0,4% in 2009) because of two factors: The large increase in saving lowered the income growth rate to almost a standstill, while the effective interest rate contribution only dropped by 0,7%. A positive development was the fact that inflation remained positive and was actually quite high during 2008 (due to the oil price shock). As a result, debt to income only stabilized without any actual drop.
In order to better account for the fisher dynamics on debt, one can examine a counterfactual scenario on Greek household debt for 2010 – 2015. As a result of lower ‘debt carrying capacity’ households decide to move into a ‘permanent’ primary surplus of 1% of income in order to pay down liabilities. The effective interest rate is assumed to go on a downward path with the inflation rate stable at a level of 3% (a rather high rate given low internal demand). Income growth is assumed at 2% for 2010/2011 and 3% afterwards since the primary surplus will be a drag on economic growth. This results on a drop of the debt ratio by only 14 points from 70,85% to 56,50%:
Debt dynamics make the drop in the debt ratio very hard and slow resulting in a stagnant and long-lasting balance sheet recession. It is also clear that an increase of the income growth rate from 2 to 3% results in an almost equal increase in the Δdebt. The basic method to espace from a balance sheet recession is higher income growth, growth which can only come from other autonomous sources (government and exports) in this scenario.
One meme often repeated about the Greek ‘tragedy’ is that the large current account deficits during the Euro area were fuelled by equally large government deficits. The profligate state was the source of the increase in foreign claims and made the equilibrium unstable since, given the large share of foreign ownership of government securities, a loss of financing would impact on both the current account (and the ability of the Greek economy to import goods) and the government budget (and the ability of the Greek government to finance deficit spending). In my view, the actual data paint a different picture.
The current account was mainly financed through private sector credit flows. These, very large annual flows, were originated by the domestic banking sector and allowed the private sector to finance an expanding trade deficit. The table below shows data for the period between 1999 and 2007 (when private credit expansion was at its height):
It is quite clear that private credit flow was usually at least twice as large as general government net lending. A simple scatter plot leads to an R² of 0.67:
It’s impressive how low the error term of the computed equation is, meaning that credit flows explain almost all of the current account movement. A similar exercise using government net lending leads to an R² of only 0.17 while the error term is quite large and equal to 3.41.
What seems to have actually happened is that domestic private credit flows financed imports. On a second phase, The Rest of the World (RoW) invested these flows in government securities instead of claims on the private sector. As a result, one can maintain that the expansion of net interest payments to the RoW, mainly in the form of government securities coupon payments, were the direct result of the private credit expansion. In any other case, the relevant securities would have been acquired by the domestic sector and consisted net income, rather than a net outflow.
This is quite evident in the RoW asset flows available in BoG financial accounts:
Although the cumulative current account deficit between 2000 and 2008 was almost €193bn (and another €31bn in 2009), most of it was ‘invested’ by the RoW on government securities, with the residual being only €62bn (and even a negative €2bn in 2009). While in the case of countries such as the USA, the RoW ended up acquiring claims on the private sector (in the form of various ABS paper), in the Greek case the foreign sector kept its ‘investment position’ as claims on the government sector, claims for which a large, liquid market existed and which were the main monetary instruments of the central bank.
In my view, such an ‘equilibrium’ was inherently more stable than an alternative one were the RoW held mainly claims on the private sector. As long as the central bank was determined to maintain stability in the government securities market, an adverse external financing shock could be avoided, something which would not be possible in the case of claims on the private sector, since in that case their underlying credit risk would be elevated due to the economic recession, lower real-estate prices and other factors.
On a related note, summing current account deficits since 1995 up to 2011 leads to a figure of -€276.4bn which should roughly correspond to the NIIP at historical costs. On the other hand, the NIIP in 2011Q4 according to BoG data was -€179.6bn, almost 100bn (48% GDP) lower. Based on historical financial accounts flows, at the end of 2011 the RoW should have held around €113bn of government securities, while the NIIP shows a figure of €71.6bn. The ‘internal devaluation’ has also had an ‘external’ effect on RoW claims.