5. Policy Issues - UCPicm.clsbe.lisboa.ucp.pt/docentes/url/jcn/MaBES/BESMacro12135.pdf · 5. Policy...

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Short run economic problemsUnemployment

Policy instrumentsPublic budget

5. Policy Issues 5.1. Equilibrium and Unemployment

Williamson, Stephen (2010) Macroeconomics, Addison Wesley, Boston USA, 4th edition, c. 17

Neves, J. (2011) Introdução à Economia, Editorial Verbo, Lisboa 9th edition c. III B) 3

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Executive Master in

Management and Banking

Macroeconomics and Business João César das Neves

The basic collision

«I point to the continued ambivalence of people to market forces. Competition is stressful because competitive markets create winners and losers. This book will try to examine the ramifications of the collision between a rapidly changing globalized economy and the unwavering human nature. The economic success of the past quarter of millennium is the outcome of this struggle; so is the anxiety that such rapid change has wrought» Alan Greenspan (2007) op.cit., p. 16.

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Unemployment rate Portugal

0

2

4

6

8

10

12

14

16

1953 1963 1973 1983 1993 2003 2013

%

broad sensesentido estrito

3

Hours worked

Wage

D

S

Act. Pop.

D

S

Voluntary Unemp.

Wage

Hours workedAct. Pop.

4

D

S

Friccional Unemp.

Wage

Hours worked

D

S

Involuntary Unemp.

Wage

Hours worked

5

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Unemployment rate Developed

countries

0

2

4

6

8

10

12

14

16

1960 1970 1980 1990 2000 2010

%

Euro ar.

USA

Japan

Portugal

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Term Contracts and Unemployment

0

5

10

15

20

25

1983 1988 1993 1998 2003 2008

% Unempl rt

Term Cont.

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Phillips curve

Alban William Housego Phillips

New Zeland, 1914-1975

Phillips, A. W. (1958) "The Relationship between

Unemployment and the Rate of Change of Money Wage

Rates in the UK 1851-1957", Economica NS 25

-5.00

0.00

5.00

10.00

15.00

20.00

25.00

30.00

0 2 4 6 8 10 12 14

Phillips curve for Portugal

Phillips curve for Portugal 1967-1973

0,00

2,00

4,00

6,00

8,00

10,00

12,00

14,00

1 1,5 2 2,5 3 3,5

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5. Policy Issues 5.2. Budget and Public Policy


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Deficits matter

«If it were true that deficits did not matter and tax cuts unmatched by spending cuts were good public policy, then why not just eliminate all taxes? Congress could borrow as much as it wanted and spend as freely as it liked, all without fear that the government’s rapidly accumulating ocean of debt would erode economic growth. Yet as we have seen time after time in developing countries, unbridled government borrowing and spending produce hyperinflation and economic devastation. So deficits must matter. The crucial question for policymakers is not, Do they hurt growth? But How much do they hurt growth?»

Alan Greenspan (2007) op. cit., p. 237.

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• Taxes

Financing Budget Expenditures

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Public Finances/GDP

0

10

20

30

40

50

60

1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

Rec/Y

Desp/Y

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Budget Deficit/GDP

-14

-12

-10

-8

-6

-4

-2

0

2

4

1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

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• Taxes


• Debt

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DAVID RICARDOLondres 1772 - Gloucestershire 1834

1817 - Principles of Political Economy and Taxation (2ªed. 1819, 3ªed. 1821)

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Ricardian EquivalenceEach year, the budget follows the restriction:

Which is equivalent to the intertemporal equation:

It is easy to see that changes in the pattern of taxes, altering Ti and Bi/p but not the trajectory of Gi and IGi , maintain the economy’s wealth and have no effect in the interest rate and the economy’s intertemporalequilibrium.

1 1 1 1 0 G1

2 2 2 2 1 G2

T + B /p = G + Tr + (1-r).B /p + I

T + B /p = G + Tr + (1-r).B /p + I ....

01 T 11 1

(1 ). /p(1 ) p(1+r) (1 )

T Tt t t GtT

t tt t

T G Tr IBr B

r r− −= =

+ ++ − − =+ +∑ ∑

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The Ricardian equivalence states the equivalence

between taxes and debt or the irrelevance of the

time trajectory of taxes. It does not hold if there are

some violations of its assumptions. The most

important are:

• Unequal distribution of the tax burden

• Debt paid beyond the life horizon of the subscribers

• Effects of distortionary taxes

• Capital markets less than perfect

Ricardian Equivalence

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Public Debt (tot. and ext) % GDP

0

20

40

60

80

100

120

1850 1870 1890 1910 1930 1950 1970 1990 2010

%

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• Taxes

Expenditure


• Debt

• Money

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Government promises...

-13

-11

-9

-7

-5

-3

-1

1

1989 1994 1999 2004 2009 2014

%

DEO

real

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All Government promise!

-12

-10

-8

-6

-4

-2

0

2

1989 1994 1999 2004 2009 2014

%

QUANTUM

Q2

PCR

PCEC98-00

PEC99-02

PEC00-04

PEC01-04

PEC02-05

PEC03-06

PEC04-07

PEC06-10

PEC07-11

PEC08-11

PEC 10-13 II

PEC 10-14

Memo

DEO

real

5. Policy Issues 5.3. The Debate in Political Economy


Neves, J.C. (2012) As 10 questões da crise, 3ª ed., Dom Quixote, Lisboa

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Change in attitude

During the 20th century there was a radical change in

attitude concerning the involvement of public

authorities in economic activity.

Several factors were influential in this change in

attitude

1. Empirical Factors

– The «great depression» of 1929-1933 is, by far,

the most important element. The confusion and

helplessness of economists facing the crisis was

very damaging.

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2. Theoretical Factors

– Keynes intervention in 1936 provided the only theoretical explanation for the collapse. He was also the only person which had foreseen the problem in his little book of 1919.

– But those events could have a darker interpretation, being seen as the confirmation of the extreme position of Karl Marx.

– And they came at time when the soviet «five-years

plan» show some apparent success.

Clearly, the economy was not stable and the market generated the anarchy its critics foresaw.

Change in attitude

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3. Methodological Factors

Science was controlling some new techniques which

promised to replace the market

– National Accounts and other statistics generated for the

first time a numeric picture of the economy.

– Primitive computers allowed the speedy treatment of this

information

– Econometrics permitted the estimation of theoretic

relationships with real data.

– The linear keynesian model and other planning methods

were particularly suited to these methods.

Change in attitude

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The economy represented by a linear system:

f1 (X1, X2, ... Xk, Xk+1, Xk+2, ... XN,, t1, t2, ... tj) = 0

f2 (X1, X2, ... Xk, Xk+1, Xk+2, ... XN,, t1, t2, ... tj) = 0

.

fN (X1, X2, ... Xk, Xk+1, Xk+2, ... XN,, t1, t2, ... tj) = 0

• k objective variables X1, X2, X3, ... XK

• j instruments t1, t2, ... Tj

(in Silva, A. Cavaco e J. C. Neves (1992) Finanças Públicas e Política

Macroeconómica, Universidade Nova de Lisboa, p.23)

“System of Equations” Approach

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Types of short-term policies

Objectives Instruments

Economic growth

Unemployment

Nominal Stability

External Balance

Fiscal policy (tax rates)

Budget policy (expenditures)

Monetary policy (M, interest rt.)

Exchange policy (exchange rt.)

Income and price policy (wages

and prices)

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The Answer

«It is difficult to imagine a sequence of events that

could more forcefully illustrate both the cost of high

unemployment and the ability of government policy

to affect unemployment. In all capitalist countries,

this «lesson» had profound influences on policy. In

the United States, it was embodied in the

Employment Act of 1946»

Lucas, R (1980) “Rules, Discretion and the Role of the Economic

Advisor” in Lucas (1981) Studies in Business-Cycle Theory, The MIT

Press

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The Employment Act of 1946

• In 1945 the American Congress debated the «Full

Employment Bill», with the purpose of imposing full

employment as one of the Government objectives.

• The debates were heated. In 1946 the Congress

finally approved the «Employment Act», with

important corrections relative to the original draft.

Source: Santoni, C. J. (1986) “The Employment Act of 1946:Some History Notes” Federal Reserve Bank of St.Louis economic review

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Problems of Policy

1- Uncertainty

- the business cycle is, in its own nature, uncertainty

- uncertain parameters (multiplier?)

- very volatile variables (Investment.)

- unknown impact of instruments

2- Political consequences of public expenditure

- elections,

- social impact

3- The growing size of the public sector implied large automatic economic stability.

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Policy delays

Policies (in months)

Recognition delay

Administrative delay

External delay

Total

Budget 3 1-15 1-3 5-21Monetary 3 0 1-20 4-23

in Silva, A. Cavaco e J. C. Neves (1992) Finanças Públicas e Política Macroeconómica, Universidade Nova de Lisboa, p.213

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Monetarist platform

• The economy is stable.

• If it was not stable flexible prices would stabilize it.

• Even if the economy is not stable and prices do nor

stabilize immediately, in the long run the adjustment

will proceed.

• Even if none of these elements work, public economic

policy would just destabilize things even more.adapted from Gordon, R. (1981) Macroeconomics, 2nd ed., Little-Brown &

Co, chap.12-3.

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Monetarist political platform

«A set of aggregative policies which would, I believe, lead and have led to satisfactory general economic performance are described:

1. a 4% annual rate of growth of M1, maintained as closely as possible on a quarter-to-quarter basis;

2. a pattern of real government expenditures and transfer payments, varying secularly but not in response to cyclical changes;

3. a pattern of tax rates, also varying secularly but not in response to cyclical changes in economic activity, set to balance the federal budget on average;

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4. A clearly announced policy that wages and price

agreements privately arrived at will not trigger

governmental reactions of any kind (aside from standard

antitrust policies and the general policy of government

preference for low over high bids);

The first three of these policies rules are taken directly from

Friedman’s writings (Rules 2 and 3 are paraphrases of those in

Friedman, M. (1948) “A Monetary and Fiscal Framework for

Economic Stability, American Economic Review, 38: 245-264.

Rule 1 is from Friedman, M. (1959) A Program for Monetary

Stability, Fordham Un.Press p.87-92)»

in Lucas, R (1980) “Rules, Discretion and the Role of the Economic Advisor”,

op. cit.

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Ronald Reagan

American President

Jan. 20, 1981 – Jan.20, 1989

Changes in policy attitudes

• What really changed the attitudes was

another real event: the 1973 oil shock:• Supply shock (1973) vs demand shock (1929)

• Keynesian reaction created «stagflation»

• Inflation generated the new oil shock in 1979

• This was a big blow to keynesian activism

• The new policy by Thatcher/Reagan

Margaret Thatcher

British Prime-minister

May 4, 1979 – Nov. 28, 1990

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Debates on the public intervention

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The «New Macroeconomics»

• The work of Lucas, Kydland e Prescott, among many others, gave birth to the «new macroeconomics», based on the general equilibrium model and the numerical description of the business cycle.

• What were the lessons this evolution taught about economic policy?

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What we saw in the models 1/3

• Budgetary policy stimulates the economy (product,

employment and investment)

• This effect is generated by the negative income effect.

People, being poorer because of taxes, work and

produce more.

• There is a fall in consumption and the economic well-

being (liquid of the expenditure benefits)

The effects of budgetary policy are positive in the economic activity, negative in well being and, above all,

very small

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• A variation in the level of money stock increases inflation on the same amount, which eliminates the effect.

• There are no effects in the future expected nominal interest rate on product, employment and investment.

• No real effects. Money is neutral.

In the long run, monetary policy should be directed solely towards price stability.

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• In the short run money levels influence real activity

• Reductions of nominal interest rates stimulate

product and investment

• Once inflation starts, it is very difficult to stabilize

again.

• Inflation adjustment should be gradual


Central banks must be more aggressive than the public towards inflation to gain the necessary credibility.

In the short run, monetary policy should care about levels of activity, changing interest rates on the face of shocks.

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Independence of the central bank

• This question is related to the recent debates about the independence of the central bank– Federal Reserve System:

• Paul A. Volker (6/Aug/1979-11/Aug/1987)• Alan Greenspan (11/Aug/1987- 31/Jan/2006)

• Ben Shalom Bernanke (31/Jan/2006 - ...)

– Central European Bank:• Willem F. Duisenberg (1/Jun./1998- 1/Nov/2003)• Jean-Claude Trichet (1/Nov/2003- 1/Nov/2011)

• Mario Draghi (1/Nov/2011- .)– Bank of Japan:

• Masaru Hayami (20/Mar./1998- 19/Mar/2003)• Toshihiko Fukui (20/Mar/2003- 19/Mar/2008)

• Masaaki Shirakawa (20/Mar/2008- ..)

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Rules vs discretion

• One of the most important results of policy analysis is

the convenience of using predictable rules in its

conduct.

• Imperfect information, multiplicity of effects and the

need avoid surprise shocks recommend that

authorities follow simple, pre-defined (not necessarily

announced) rules, in an automatic reaction to shocks

• The most famous of all the rules is the so called

«Taylor rule» Studies have shown this rule and some

variants replicate to the of several influential central

banks

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The «Taylor rule» 1/3

John B. TaylorYonkers, New York (1946- )

Taylor, John B. (1993) “Discretion Versus Policy Rules in Practice,”Carnegie-Rochester Series on Public Policy, North-Holland, 39, pp. 195-214).

In the rule the desired interest rate change (î) depends on inflation (π) and the product gap (x), with a shock (v)

are desired levels of the variables

π x

*π x

*π

δ π δ x

or ( π) δ (π π) δ x

with δ 0, δ 0 , where π, e

t t t t

t t t

x

i v

i r

i r

= + +

= + + − +

> >

$

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This rule includes some policy characteristics which

correspond to the referred optimal conditions :

• It generates a gradual adjustment of inflation to

the target.

• Nominal interest rates adjust more than inflation.

Real interest rate forces inflation.

• The interest rate reacts to the «output gap» and

not to the output level


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Estimates of this rule for the USA, in particularly comparing the period before 1979 with the Volker/Greenspan, period show that:

• Before 1979 the values of δx were positive and significant and δπ was significantly smaller than 1.

• After 1979 δπ is bigger than 1 e δx became non significantly different from zero.

(Clarida, R.; J. Gali, e M. Gertler (2000) “Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory” Quarterly Journal of Economics, vol. CXV, issue 1, 147-180)


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Inflation rate US

-2.5

2.5

7.5

12.5

Dec-64 Sep-78 May-92 Jan-06

%

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Central banks intervention rates

0

2

4

6

8

10

12

14

16

Fed

ECB/Bund

BoEn

BoJP

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Volcker’s courage

«President Carter backed Volcker in the spring of 1980,

declaring inflation to be the nation’s number one

problem (…) Doing what Volcker did took exceptional

courage –I thought so at the time and believed it

even more strongly after I became chairman myself.

Though he and I rarely discussed his experience of

those events, I can imagine how tough it was for him

to push America into the brutal recession of the early

1980s.» Greenspan (2007) op.cit., p. 85

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Inflation rate US

-2.5

0

2.5

5

7.5

10

12.5

15

Dec-77 Jun-83 Dec-88 Jun-94 Nov-99 May-05 Nov-10

%

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Myth No. 1: Monetary policy

causes booms and busts

«Greg Mankiw, former chairman of the Council of

Economic Advisers, wrote the following in a 2002

paper: “No aspect of U.S. policy in the 1990s is more

widely hailed as a success than monetary policy. Fed

Chairman Alan Greenspan is often viewed as a

miracle worker.” Or, as Mr. Mankiw later asks, was

Mr. Greenspan just lucky?» (op. cit. p.2)

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Central banks intervention rates

0

1

2

3

4

5

6

7

8

Fed

ECB

BoEn

BoJP

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Central bank achievement?

«Many economists in fact credit central bank monetary policy as the key factor in the last decade’s reduction in inflation worldwide. I would like to believe that. I do not deny that we adjusted policy to be consonant with global disinflationary trends as they emerged. But I very much doubt that either policy actions or central bank anti-inflationary credibility played the leading role in the fall of long-term interest rates in the past one to two decades.»

Alan Greenspan (2007) The Age of Turbulence, Adventures in a new world, The Penguin Press, New York, p. 390

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US interest rates (10 years Government Securities and 6 months

Treasury Bills)

0

2

4

6

8

10

12

14

16

18

Jan-53 Sep-66 May-80 Jan-94 Oct-07

10y Gov.Sec.

6m T-bills

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World Inflation

0

5

10

15

20

25

30

35

40

1970 1975 1980 1985 1990 1995 2000 2005 2010

%

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World Inflation

0

20

40

60

80

100

120

140

1980 1990 2000 2010

%

WorldAdvanc.

Developing

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The new economic world

«The end of the cold war (…) has little to

challenge it as the second half of the century’s most significant

geopolitical event (…) Soon

well over a billion workers, many of them well educated, all low

paid, began to gravitate to the world competitive marketplace

from economies that had been almost wholly or in part

centrally planned and insulated from global competition (…)

Many hundreds of millions of people, mainly in China and India,

have yet to make the transition. This movement of workers into

the marketplace reduced world wages, inflation, inflation

expectations, and interest rates, and accordingly significantly

contributed to rising world economic growth.» Greenspan

(2007) op.cit., p. 382

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Return to the old world?

«The rate of flow of workers to competitive labourmarkets will eventually slow, and as a result, disinflationary pressures should start to lift (…) Accordingly an easing of disinflationary pressures should foster a pickup of price inflation and wage growth in the United States. (…) How the Federal Reserve responds to a reemergence of inflation and expected falling world savings propensities will have a profound effect not only on how US economy of 2030 turns out but also, by extension, on our trading partners worldwide.» Greenspan (2007) op.cit, p. 477-478

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Summary of policy recommendations

The effects of budgetary policy are positive in the economic activity, negative in well being and, above all,

very small

In the long run, monetary policy should be directed solely towards price stability.

In the short run, central banks must be more aggressive than the public towards inflation to gain the necessary

credibility.

Executive Master in



Political influence of these results

• How far were these results influential on the real life

economic policy of the last decades?

• Did the specific government practice progress

something since the 1946’s Employment Act and the

Monetarist platform?

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USA

• The 1973 oil crisis generated pressures to create a new

Employment Act, thirty years after the first one.

• Senator Hubert H. Humphrey e and representative

Augustus F. Hawkins presented the «Full Employment

and Balanced Growth Bill» in 1976. This proposal was a

copy of the original «Full Employment Bill» of 1945.

• The Humphrey/Hawkins Bill has enormous changes.

When president Carter signed the Bill in October 27,

1978, it was a very different law.

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European Union

Treaty on European Union (signed in Rome in 1957

and modified in Maastricht in 1992)

Title VI - ECONOMIC AND MONETARY POLICY

Chapter 1- Economic policy

Chapter 2 - Monetary policy

Chapter 3 - Institutional provisions

Chapter 4 - Transitional provisions

On this, no change was made by the Treaty of Lisbon amending the Treaty on European Union and the Treaty establishing the European Community, signed at Lisbon, 13 December 2007

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Chapter 1 - Economic policy

Article 104 1. Member States shall avoid excessive government deficits.

2. The Commission shall monitor the development of the budgetary situation and of the stock of government debt in the Member States with a view to identifying gross errors. In particular it shall examine compliance with budgetary discipline on the basis of the following two criteria:

(a) whether the ratio of the planned or actual government deficit to gross domestic product exceeds a reference value, unless

- either the ratio has declined substantially and continuously and reached a level that comes close to the reference value;

- or, alternatively, the excess over the reference value is only exceptional and temporary and the ratio remains close to the reference value;

(b) whether the ratio of government debt to gross domestic product exceeds a reference value, unless the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace.

The reference values are specified in the Protocol on the excessive deficit procedure annexed to this Treaty.

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THE HIGH CONTRACTING PARTIES,

DESIRING to lay down the details of the excessive deficit procedure referred to in Article 104c of the Treaty establishing the European Community,

HAVE AGREED upon the following provisions, which shall be annexed to the Treaty establishing the European Community:

Article 1

The reference values referred to in Article 104c(2) of this Treaty are:

- 3% for the ratio of the planned or actual government deficit to gross domestic product at market prices;

- 60% for the ratio of government debt to gross domestic product at market prices.

PROTOCOL on the excessive deficit procedure

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Monetary policy Article 105

1. The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 3a.

2. The basic tasks to be carried out through the ESCB shall be:

- to define and implement the monetary policy of the Community;

- to conduct foreign exchange operations consistent with the provisions of Article 109;

- to hold and manage the official foreign reserves of the Member States;

- to promote the smooth operation of payment systems.

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-15

-10

-5

0

1969 1979 1989 1999 2009

% G

DP

US Budget Deficit (% GDP)

US Budget Deficit (% GDP)

-30

-25

-20

-15

-10

-5

0

5

10

1900 1950 2000

37

40

50

60

70

80

90

100

1969 1979 1989 1999 2009

% G

DP

US Public Debt (% GDP)

US Public Debt (% GDP)

0

20

40

60

80

100

120

140

1790 1840 1890 1940 1990

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Myth No. 4: The U.S. government

debt is big

«The key measure here is privately held interest-bearing federal government debt, which includes debt held by foreign central banks, and does not include debt held by the Fed or government debt held by the government. So let’s turn to the historical data once again. Privately held interest-bearing debt relative to income peaked during World War II, fell through the early 1970s, rose again through the early 1990s, and then fell again until 2003. Even though that number has been rising in recent years (except for the most recent one), it is still at levels similar to the early 1960s, and lower than levels in most of the 1980s and 1990s. This debt level was not alarming then, and it is not alarming now. From a historical perspective, the current U.S. government debt is not large.» (op. cit. p.2)

Executive Master in



Total Public Debt (% GDP)

0

20

40

60

80

100

120

140

160

180

1790 1840 1890 1940 1990

China

India

Italy

Russia

US

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0

50

100

150

200

250

300

350

400

450

1790 1840 1890 1940 1990

Argentina

Brazil

Greece

Japan

US

Executive Master in




0

50

100

150

200

250

300

1790 1840 1890 1940 1990

France

Belgium

Germany

UK

US

40

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0

20

40

60

80

100

120

140

160

180

1790 1840 1890 1940 1990

Iceland

Ireland

Portugal

Spain

US

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European Total Public Debt (% GDP)

0

20

40

60

80

100

120

140

1970 1975 1980 1985 1990 1995 2000 2005 2010

France

Belgium

Germany

UK

Italy

Greece

Ireland

Portugal

Spain

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2010 (% GDP) Ext tot 2010 (% GDP) Pub(g)Ireland 1041.6 Japan 225.9Iceland 914.8 Greece 144.0UK 410.5 Italy 117.5Netherlands 305.9 Iceland 115.6Belgium 266.3 Belgium 100.2Portugal 238.0 Ireland 93.6Switzerlad 232.7 USA 92.7Sweden 201.4 France 84.2Denmark 197.4 Portugal 83.1France 192.0 Canada 81.7Spain 173.9 Germany 78.8Greece 171.5 UK 76.7Finland 159.8 Hungary 72.6Hungary 154.1 Netherlands 67.4Germany 149.1 Spain 63.5Norway 128.9 Norway 54.3Italy 115.8 Finland 50.0USA 94.0 Sweden 41.7N. Zeland 74.9 Denmark 40.6Canada 65.3 Switzerlad 39.5Japan 38.7 N.Zeland 31.0

Portuguese external

debt is high, below

much below Ireland,

Great-Britain and even

the Netherlands and

Belgium, although

much above Greece,

Spain, Italy, etc.

Portuguese public debt

is not very high, well

below Greece, Ireland,

USA and France,

although above Spain

and Germany. There is

some hidden debt

(public enterprises and

public-private

partnerships) which

could raise this value

(some say as high as

120% of GDP).Source: World Bank Source: IMF

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Finance vs Economics

• The case of Belgium:

– Has higher external and public debt than Portugal

– Budget deficit is around de 4% do GDP

– Had in 2009 a more severe crisis than Portugal (-3.1% vs -2.7)

– Is in a political crisis since 2007 and without a Government since June 2010

– Nobody talks about the Belgium debt problems. Why?

• Belgium always has its balance of payments in a asurplus

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Internal vs external debt

• The case of Japan:

– Japan is the country in the world with the highest public

debt of all

• Japan’s debt is 225.9% of Japanese GDP

• This is 9 731 772 000 US$

– Nobody talks about the Belgium debt problems. Why?

• Japan’s debt is mostly to Japanese

Executive Master in



When is a debt too high?

face surprisingly low thresholds for external borrowing, beyond which risks of default or restructuring become significant» Reinhart, Carmen M. and Kenneth S. Rogoff (2009) This time is different; Eight centuries of financial folly , Princeton University Press, p.32

«Debt intolerance can be captured systematically

by a relatively small number of variables,

principally a country’s own history of default

and high inflation. Debt intolerant countries

43

Executive Master in



How to face a financial crisis?

Analysis based upon 124 financial crises described in:

Laeven, Luc and Fabian Valencia (2008) Systemic Banking

Crises: A New Database, IMF Working paper, WP/08/224

Executive Master in



Trigger for the crisis

• a loss of depositor confidence (triggering a deposit

run)

• regulatory recognition of bank insolvency

• the knock-on effects of financial asset market

disturbances outside the banking system, including

exchange rate and wider macroeconomic

pressures.

44

Executive Master in



Dilemma: moment of intervention

• the first big difficulty is determining when to

intervene.

– intervening too soon would save bad debts and

promotes imprudence;

– too late would only find ruins, as in 1929.

• Alan Greenspan intervened too soon in the last crisis

and is being criticized now for that

Executive Master in



Two policy phases

1. Containment phase: restoring public confidence to

minimize the repercussions on the real sector of

the loss of confidence by depositors and other

investors in the financial system.

2. Resolution phase: actual financial, and to a lesser

extent operational, restructuring of financial

institutions and corporations.

45

Executive Master in



Containment phase

(a) suspension of convertibility of deposits, which prevents bank depositors from seeking repayment from banks,

(b) regulatory capital forbearance, which allows banks to avoid the cost of regulatory compliance (for example by allowing banks to overstate theirequity capital in order to avoid the costs of contractions in loan supply),

(c) emergency liquidity support to banks,

(d) a government guarantee of depositors.

(a) suspension of convertibility of deposits, which prevents bank depositors from seeking repayment from banks

12%

(b) regulatory capital forbearance, which allows banks to avoid the cost of regulatory compliance

67%

(c) emergency liquidity support to banks 71%

(d) a government guarantee of depositors 29%

Containment phase

46

Executive Master in



Cental banks total assets(Jul 2007 = 100)

João César das Neves

0

50

100

150

200

250

300

350

400

2006 2007 2008 2009 2010 2011 2012 2013

Fed

BofE

BoJ

BCE

Executive Master in



Dilemma: which institutions to

save?

• Once intervention is decided, the central bank must

decide in which institutions should be saved

– Must intervene in all which have systemic risk, for which it

is responsible;

– It is very difficult to determine this in the specific cases

• Lehman Brothers care was very symbolic

– It fell in September 15, 2008, with 613 billion debt, the

largest bankruptcy in history (the previous record

WorldCom in July 2004 was 104 billions)

47

Executive Master in



Resolution phase

a) conditional government-subsidized, but decentralized, workouts of distressed loans;

b) debt forgiveness;

c) the establishment of a government-owned asset management company to buy and resolve distressed loans;

d) government-assisted sales of financial institutions to new owners, typically foreign;

e) government-assisted recapitalization of financialinstitutions through injection of funds.

(a) conditional government-subsidized, but decentralized, workouts of distressed loans;

-

(b) debt forgiveness; -

(c) the establishment of a government-owned asset management company to buy and resolve distressed loans;

48%

(d) government-assisted sales of financial institutions to new owners, typically foreign;

51%

(e) government-assisted recapitalization of financial institutions through injection of funds.

76%

Resolution phase

48

Executive Master in



Policy for the 2009 crisis

«Mr Mishkin [then a governor of the Federal Reserve]

recognised the potential for a financial crisis in 2007, of

course. Mr Bernanke certainly did as well. But

recommending pre-emptive monetary policies on the

scale of the policies that were applied later on would

have been like turning abruptly off the road because of

the potential for someone suddenly to swerve head-on

into your lane. The best and only realistic thing you can

do in this context is to keep your eyes open and hope for

the best.» Lucas, Robert E. (2009) “In defence of the dismal science”, in The Economist,

August 6th, 2009

Executive Master in




«After Lehman collapsed and the potential for crisis had become a reality, the situation was completely altered. The interest on Treasury bills was close to zero, and those who viewed interest-rate reductions as the only stimulus available to the Fed thought that monetary policy was now exhausted. But Mr Bernanke immediately switched gears, began pumping cash into the banking system, and convinced the Treasury to do the same. Commercial-bank reserves grew from $50 billion at the time of the Lehman failure to something like $800 billion by the end of the year. The injection of Troubled Asset Relief Programme funds added more money to the financial system..»

Lucas, Robert E. (2009) “In defence of the dismal science”, in The Economist, August 6th, 2009

49

Executive Master in




«There is understandable controversy about many aspects of these actions but they had the great advantages of speed and reversibility. My own view, as expressed elsewhere, is that these policies were central to relieving a fear-driven rush to liquidity and so alleviating (if only partially) the perceived need for consumers and businesses to reduce spending. The recession is now under control and no responsible forecasters see anything remotely like the 1929-33 contraction in America on the horizon. This outcome did not have to happen, but it did.»

Lucas, Robert E. (2009) “In defence of the dismal science”, in The Economist, August 6th, 2009

The «Great Depression»Biggest Cyclical (peak to trough) GDP movements 1929-1935

Maddison, Angus (1995) Monitoring the World Economy 1820-1992, OCDE, Paris., table

3-7

Chile -30,0 Polónia -20,7 Indonésia -9,3

Canadá -29,6 Checoslováquia -18,2 Austrália -9,2

EUA -28,5 França -14,7 China -8,7

Perú -25,8 Nova Zelândia -14,6 Suiça -8,0

Alemanha -24,5 Argentina -13,7 Bélgica -7,9

Venezuela -22,6 Bulgária -12,7 Holanda -7,8

Áustria -22,5 Jugoslávia -11,9 Noruega -7,8

México -20,8 Hungria -9,4 Japão -7,3

50

The «Great Recession»Biggest Cyclical (peak to trough) GDP movements 2008-2010 (%)

International Monetary Fund (2010) World Economic Outlook, April

1929 2009 1929 2009 1929 2009

Chile -30,0 -1.5 Polónia -20,7 1.7 Indoné. -9,3 4.5

Canadá -29,6 -2.6 Chec.+ Eslov -18,2 -4.4 Austrál. -9,2 1.3

EUA -28,5 -2.4 França -14,7 -2.2 China -8,7 8.7

Perú -25,8 0.9 Nova Zelând -14,6 -1.6 Suiça -8,0 -1.5

Alemanh -24,5 -5.0 Argentina -13,7 0.9 Bélgica -7,9 -3.0

Venezuel -22,6 -5.8 Bulgária -12,7 -5.0 Holanda -7,8 -4.0

Áustria -22,5 -3.6 Ex-Jugosl. -11,9 -4.7 Norueg -7,8 -1.5

México -20,8 -6.5 Hungria -9,4 -6.5 Japão -7,3 -6.3

Executive Master in



Great Depression vs Great

Recession

-15

-10

-5

0

5

10

15

20

25

30

35

Chi

le

Can

ada

US

A

Per

u

Ger

man

y

Ven

ezue

la

Aus

tria

Mex

ico

Pol

and

Cze

chos

lova

kia

Fra

nce

New

Zea

land

Arg

entin

a

Bul

garia

Yug

osla

via

Hun

gary

Indo

nesi

a

Aus

tral

ia

Chi

na

Sw

itzer

land

Bel

gium

Hol

land

Nor

way

Japa

n

1929-1935

2008-2010

-

-

-

-

-

-

-

Inverted scale

51

-15

-10

-5

0

5

10

0 1 2 3 4 5 6 7

USA

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

0 1 2 3 4 5 6 7

Japan

-10

-8

-6

-4

-2

0

2

4

6

8

10

0 1 2 3 4 5 6 7

Germany

-8

-6

-4

-2

0

2

4

6

8

10

0 1 2 3 4 5 6 7

Hungary

Dow Jones Industrial Average

0

100

200

300

400

500

600

1 6 11

Set.1921-Feb.1933

Jul 1984-Nov1988

Nov.1988-Set2002

Set.2002-Mai2010

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