The Debt Challenge in Europe Alan Ahearne and Guntram Wolff October 2011

1. The Debt Challenge in Europe Alan Ahearne and Guntram Wolff October 2011

2. Outline • The challenge: debt overhang and price adjustment. • Large increase in private debt prior to the crisis. • Balance-sheet adjustments underway. • Examine previous experiences with corporate and household deleveraging. • Options for policymakers.

3. Adjustment mechanisms in EMU • Membership of euro imposes constraints on macroeconomic policy. • Smooth economic adjustment depends crucially on the adjustment of intra-area real exchange rates and factor mobility (European Commission, 2006 and 2008). • Competitiveness channel (EC, 2008; Honohan and Lane, 2003). • Real interest rate channel (Walters critique). • Factor mobility and Optimum Currency Areas (Mundell, 1961; McKinnon, 1963; and Kenen, 1969).

4. Competitiveness channel versus real interest rate channel • The competitiveness channel is expected to outweigh the real interest rate channel over the longer haul. (European Commission, 2006). • “What is lost when inflation is above the average is much greater than what you could theoretically gain with a lower level of real rates. This is very important” (Jean-Claude Trichet, 2006).

5. But what about debt? • Interaction between public debt and private debt. • Large-scale fiscal consolidation → reduce income → financial distress and banking problems → further depress economic growth (Eggertsson and Krugman, 2010). • Interaction between needed improvements in competitiveness and high levels of private indebtedness. • Depreciation of the real exchange rate through cuts in nominal wage rates and prices eventually boosts incomes. But there’s a timing issue. (Fisher, 1933). • Labour mobility and mortgage debt.

6. High debt levels in crisis countries

7. Significant competitiveness adjustments required

8. Fiscal deficits have offset increases in corporate net lending Table 1: Changes in non-financial corporations and government net lending (% of GDP) Note: Adjustment in net lendingsince the year at which corporate borrowing was largest. *Excludes banking support. Source: EUROSTAT

9. Effects of corporate deleveraging

10. Large increases in household indebtedness Household debt as % of disposable income

11. Why has household indebtedness risen? • Permanent income (or life-cycle) model of consumption and saving relates decisions on savings and borrowings to life-cycle factors. • Savings are typically low or negative during an individual’s early working years and during retirement when income is low. Households save at a higher rate during late working years when income is highest. • Real interest rates. • Future income expectations. • Demographics. • A major driver of the rise in indebtedness has been the growth in mortgage debt.

12. Interaction between government and household debt Gross government and household debt % of GDP

13. Interaction between government and household debt Net government and household debt % of GDP

14. Household deleveraging during the current crisis

15. Previous episodes of household deleveraging Household debt as a % of disposable income

16. Growth was key to previous episodes of deleveraging Real GDP growth

17. Policy options • Successful deleveraging questionable unless growth is restored in the euro area as a whole. • Financial market conditions must be normalised. • Interest rate cuts by the ECB. • Improved incentives for investment in Germany. • Unused structural funds could be spent on targeted wage subsidies in the tradable sector → job creation in the export sector. • Structural reforms to facilitate the re-allocation of the work force to the tradable sector. • Fiscal consolidation should take into account heavily indebted cohorts. • Debt relief, where necessary.