The Debt Challenge in Europe

Alan Ahearne and Guntram Wolff

October 2011

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.

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).

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).

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.

High debt levels in crisis countries

Figure 1: Net external financial assets as % of GDP (2009)Figure 2: Net assets in the different domestic sectors as % of

GDP (2009)

Source: EUROSTAT Source: EUROSTAT

Significant competitiveness adjustments required

Fiscal deficits have offset increases in corporate net lending

  Corporate sectorGovernmentsector Start year

EA 17 2.7 -3.9 2008Ireland 3 -11.9* 2007Greece 4 -3.7 2007Spain 8.9 -11.2 2007Italy  1.9 -3 2007Portugal 5.4 -5.6 2008

Table 1: Changes in non-financial

corporations and government net

lending

(% of GDP)

Note: Adjustment in net lending since the year at which corporate borrowing was largest. *Excludes banking

support.

Source: EUROSTAT

Effects of corporate deleveraging

Table 2: Consequences of corporate balance sheet adjustment

 t=0 t=4 Actual change 

(2)

Average change in 

entire sample

Effect of balance sheet 

adjustment

Number of episodes

 (A) (B) (C)=(B)-(A) (D) (E)=(C)-(D) (F) 

Debt / GDP 60.3 58.4 -1.9 5.2 -7.1 12

Leverage  101.2 85.3 -15.9 -1.2 -14.7 12

Liquidity / VA 30.0 33.4 3.4 0.9 2.5 10

Investment / VA 26.1 23.2 -2.9 -0.2 -2.8 16

Savings / VA 17.2 22.3 5.0 0.4 4.6 16

Compensation of employees / VA

60.2 55.6 -4.6 -0.9 -3.7 20

Real growth   

6.6 9.9 -3.3 24

Large increases in household indebtedness

0

50

100

150

200

250

300

1999

2009

Household debt as % of disposable income

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.

Interaction between government and household debt

Belgium

France

Germany

Greece

Ireland

Italy

Portugal

Spain

Euro area

0

20

40

60

80

100

120

140

0 20 40 60 80 100 120 140 160

Government gross debt

Ho

us

eh

old

s' g

ros

s d

eb

t

Gross government and household debt

% of GDP

Interaction between government and household debt

Belgium

FranceGermany

Ireland

Italy

Portugal

Spain

Euro area

-250

-200

-150

-100

-50

0

0 20 40 60 80 100 120

Government net debt

Ho

use

ho

lds'

net

deb

t

Net government and household debt

% of GDP

Household deleveraging during the current crisis

 Table 3: Household debt, 2007-2009 (% of

disposable income)

  2007  2008  2009 Austria   86  87  87 Belgium   77  79  83 Denmark   255  262  275 Euro area  94  95  97 Finland   97  98  101 France   73  76  77 Germany   93  89  89 Ireland   194  198  199 Italy   57  57  61 Netherlands   222  230  241 Norway   177  177  n.a. Portugal   128  129  131 Spain   130  127  125 Sweden   131  133  140 Switzerland   170  168  n.a. U.K.   152  153  149 

Previous episodes of household deleveraging

40.0

60.0

80.0

100.0

120.0

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Finland

Sweden

UK

Household debt as a % of disposable income

Growth was key to previous episodes of deleveraging

1989 1990 1991 1992 1993 1994

Finland 5.4 0.1 -6.0 -3.6 -0.9 3.7

Sweden 2.8 1.0 -1.1 -1.2 -2.1 3.9

UK 2.3 0.8 -1.4 0.1 2.2 4.3

2007 2008 2009 2010 2011f 2012f

Greece 4.3 1.0 -2.3 -4.4 -5.0 -2.0

Ireland 5.2 -3.0 -7.0 -0.4 0.4 1.5

Italy 1.5 -1.3 -5.2 1.3 0.6 0.3

Portugal 2.4 0.0 -2.5 1.3 -2.2 -1.8

Spain 3.6 0.9 -3.7 -0.1 0.8 1.1

Real GDP growth

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.