Thursday, August 22, 2013

22/8/2013: Slow Moving Sovereign Debt Crises: a new MIT Paper

Guido Lorenzoni and Ivan Werning (LW, 2013) new paper "Slow Moving Debt Crises" (June 30, 2013, MIT Department of Economics Working Paper 13-18. theoretically links the environment and policies conditions that can lead to self-fulfilling increases in sovereign interest rates.

To do so, the authors use a model of the dynamics of debt and interest rates in a setting where default is driven by insolvency. "Fiscal deficits and surpluses are subject to shocks but influenced by a fiscal policy rule. Whenever possible the government issues debt to meet its current obligations and defaults otherwise."

The result is a model that has multiple equilibria where both "low and high interest rate equilibria may coexist". There are self-fulfilling risks as "higher interest rates, prompted by fears of default, lead to faster debt accumulation, validating default fears. We call such an equilibrium a slow moving crisis, in contrast to rollover crises where investor runs precipitate immediate default." In a sense, Italy, and potentially the rest of the euro area periphery, ex-Ireland, appear to be stuck in this 'slow moving debt crisis'.

In September 2012, commenting on the ECB announcement of OMT, the ECB’s president,
Mario Draghi, clearly linked the on-going sovereign debt crisis in euro area peripheral states to a self-fulfilling crisis: “…we are in a situation now where you have large parts of the Euro Area in what we call a bad equilibrium, namely an equilibrium where you have self-fulfilling expectations. You may have self-fulfilling expectations that generate, that feed upon themselves, and generate adverse, very adverse scenarios. So there is a case for intervening to, in a sense, break these expectations [...]”

According to LW (2013): "If this view is correct, a credible announcement is all it takes to rule out bad equilibria, no bond purchases need to be carried out. To date, this is exactly how it seems to have played out."

In the LW (2013) model, "the government faces a fluctuating path of fiscal surpluses or deficits, that are affected by shocks and the current debt level. Each period, it attempts to meet these obligations by visiting a credit market, issuing bonds to a large group of risk-neutral investors. The capacity to borrow is limited endogenously by the prospect of future repayment and default occurs when a government’s need for funds exceeds this borrowing capacity. In equilibrium, bond prices incorporate the probability of default."

Bonds can be issued as short-term and long-term. "In the case of short-term debt", LW (2013) show that "the equilibrium bond price function (mapping the state
of the economy into bond prices) is uniquely determined."

The main point, however, is that uniqueness of he price function "does not imply that the equilibrium is unique. Multiplicity arises from what we call a Laffer curve effect: revenue from a bond auction is non-monotone in the amount of bonds issued. If the borrower targets a given level of revenue, then there are multiple bond prices consistent with an equilibrium."

"With long-term bonds the price function is no longer uniquely determined, because a
bad equilibrium with lower bond prices in the future now feeds back into current bond
prices. In addition, the existence of a good and bad equilibrium may be temporary. For
example, if we follow the bad equilibrium path for a sufficiently long period of time,
the debt level may reach a level for which there exists a unique continuation equilibrium with high interest rates; the bad equilibrium may set in."

This is important to the current case, as it links directly high level debt starting position to the bad equilibrium outcome without the need to reference investors' withdrawal from the funding market. This is the core difference to the traditional crises and LW (2013) call this a 'slow moving debt crisis' "to capture the fact
that it develops over time through the accumulation of debt" as distinguished "from liquidity or rollover debt crises". The 'liquidity crisis' occurs when "current investors, …pull out of the market entirely, leading to a failed bond auction; complete lack of credit then triggers default, analogous to depositors running on banks".

LW (2013) model "can be used to identify a “safe” region of parameters, for which
the equilibrium is unique. In particular, the safe region corresponds to a low initial debt level and to high responsiveness of the surplus to debt in the fiscal policy rule."

Very interesting conclusion from the LW (2013) paper is that "with long term debt, a slow moving crisis, by its very nature is due to a breakdown in the coordination of investors at different dates. As a result, it cannot be averted by coordinating investors meeting in a given market at a certain moment of time. If, instead, the borrower could commit to a certain bond issuance, this would eliminate the multiplicity problem." The commitment that ends such a crisis, in theory, implies commitment to specific steady levels of borrowing - a deficit path - while maintaining certain debt bounds forward. In contrast to mainstream literature, LW (2013) "assume that the borrower cannot commit to a certain bond issuance, because it cannot adjust its spending needs. Thus, it will issue the bonds needed to finance its obligations." The reason for this assumption is that while the borrowers "can control the amount of bonds issued… during any given market transaction or offer", in the long run, the actual amounts raised in the markets will not be fully predictable. Per LW (2013): "consider a borrower showing up to market with some given amount of bonds to sell. If the price turns out to be lower than expected the borrower may quickly return to offer additional bonds for sale to make up the difference in funding [and thus] …the overall size of the bond issuance remains endogenous to the bond price."

LW (2013) conclude that "it seems difficult to dismiss the concern that a country may find itself in a self-fulfilling “bad equilibrium” with high interest rates. In our model, bad equilibria are not driven by the fear of a sudden rollover crisis, as commonly modeled in the literature following Giavazzi and Pagano (1989), Alesina et al. (1992) and Cole and Kehoe (1996) and others. Thus, the problems these “bad equilibria” present are not resolved by attempts to rule out such investor runs. Instead, high interest rates can be self fulfilling because they imply a slow but perverse debt dynamic. Our results highlight the importance of fiscal policy rules and debt maturity in determining whether the economy is safe from the threat of these slow moving crises."
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