14/12/19: Governance and Government Debt

What I am reading this week: a new paper via EFMA, titled "Governance and Government Debt" by João Imaginário and Maria João Guedes, available here: https://efmaefm.org/0EFMAMEETINGS/EFMA%20ANNUAL%20MEETINGS/2019-Azores/papers/EFMA2019_0184_fullpaper.pdf.

The paper looks at "the relationship between Worldwide Governance Indicators [a proxy for governance quality] and Government Debt in 164 countries for the period between 2002 and 2015." Using fixed effects (FE) and generalized method of moments (GMM) models the authors show that "governance quality is negatively and statistically related with government debt. For Low Income countries was found evidence that better governance environment is associated with lower public debt levels."

More specifically, "for a set of 164 countries on a period between 2002 and 2015, ... estimation results for FE model suggest that Control of Corruption (CC) and Voice and Accountability (VA) indexes are negative and statistically significant on influencing government debt. In part, this result confirms our Hypothesis 1 that better governance quality is associated with lower levels of public
debt." But the study also shows that these 'global' effects are predominantly driven by the presence of low income countries in the full sample. The authors find that "the link between good governance quality and government debt reduction is more evident for Low Income countries."

As a caveat, the authors do find that overall higher score in the World Governance Indicators Index (as opposed to specific sub scores) has a negative and statistically significant impact on the levels of government debt, so that overall higher measure of governance quality is associated with lower government debt for the High Income economies. The magnitude of this effect was reasonably large, as well.

17/5/15: Public Debt, Private Debt… Someone Thinks There Might Be Consequences

Remember last year vigorous debate about whether debt (in particular real economic debt - as I call it, or non-financial debt - as officialdom calls it) matters when it comes to growth? Well, the debate hasn't die out… at least not yet. And some heavy hitters are getting into the fight. Òscar Jordà, Moritz HP. Schularick and Alan M. Taylor paper, "Sovereigns versus Banks: Credit, Crises and Consequences", Working Paper No. 3: http://ssrn.com/abstract=2585696

Ok, so some key preliminaries: "Two separate narratives have emerged in the wake of the Global Financial Crisis. One interpretation speaks of private financial excess and the key role of the banking system in leveraging and deleveraging the economy. The other emphasizes the public sector balance sheet over the private and worries about the risks of lax fiscal policies." The problem is that the two 'narratives' "…may interact in important and understudied ways", most notably via debt and debt overhangs.

The authors examine "the co-evolution of public and private sector debt in advanced countries since 1870. We find that in advanced economies significant financial stability risks have mostly come from private sector credit booms rather than from the expansion of public debt."

Time for Krugmanites to pop some champagne? Err, not too fast: "However, we find evidence that high levels of public debt have tended to exacerbate the effects of private sector deleveraging after crises, leading to more prolonged periods of economic depression."

Wait, what? A state indebted to the point of losing its shirt (or rather default on pay awards to trade unionised workers and retirees) imposes cost on private sector that can be detrimental during private sector own deleveraging? Yeah, you betcha. It is called power of taxation. Just as during the current crisis the Governments world wide gave no damn as to whether you and I can pay kids schools fees, health insurance and mortgages, so it was thus before.

"We uncover three key facts based on our analysis of around 150 recessions and recoveries since 1870:

1. in a normal recession and recovery real GDP per capita falls by 1.5 percent and takes only 2 years to regain its previous peak, but in a financial crisis recession the drop is typically 5 percent and it takes over 5 years to regain the previous peak; 
2. the output drop is even worse and recovery even slower when the crisis is preceded by a credit boom; and 
3. the path of recovery is worse still when a credit-fuelled crisis coincides with elevated public debt levels. Recent experience in the advanced economies provides a useful out-of-sample comparison, and meshes closely with these historical patterns. Fiscal space appears to be a constraint in the aftermath of a crisis, then and now."

Now, take a more in-depth tour of the changes in fiscal and private non-financial debt across 17 advanced economies since 1870s:

Oh, yeah… 1950s and 1960s public deleveraging was done by leveraging up the real economy. And it didn't stop there. It got much much worse… instead of deleveraging one side of the economy, both public and private sides continued to binge on debt. Through the present crisis.

So "what does the long-run historical evidence say about the prevalence and effects of private and public debt booms and overhangs? Do high levels of public debt affect business cycle dynamics, as the public debt overhang literature argues? Are the effects of either variety of debt overhang more pronounced after financial crisis recessions?"

So here are the results:

So the results provide "…a first look at over 100 years of the inter-relationships of private credit and sovereign debt. We end with five main conclusions":

1. "…while public debt has grown in most countries in recent decades, the extraordinary growth of private sector debt (bank loans) is chiefly responsible for the strong increase of total liabilities in Western economies. About two thirds of the increase in total economy debt originated in the private sector. ...Sovereign and bank debts have generally been inversely correlated over the long run, but have increased jointly since the 1970s. In modern times, the Bretton-Woods period stands out as the only period of sustained public debt reduction, both in expansions and recessions."
2. "…in advanced economies financial stability risks originate primarily in the private sector rather than in the public sector. To understand the driving forces of financial crises one has to study private borrowing and its problems. In the very long run, if we run a horse race between the impact of changes or run-ups in private credit (bank loans) and sovereign debt as a predictor of financial crisis and its associated distress, private credit is the more significant predictor; sovereign debt adds little predictive information. This fits with the events of 2008 well: with the exception of fiscal malfeasance in Greece most other advanced countries did not have obvious public debt problems ex ante. Of course, ex post, the fierce financial crisis recession would wreak havoc on public finances via crashing revenues and rising cyclical expenditures."
3. "…with a broader and longer sample we confirm that private debt overhangs are a regular feature of the modern business cycle. We find that once a country does enter a recession, whether it is an ordinary type or a financial-crisis type of recession, if it carries the legacy of a large private credit boom then the post-recession output path of the economy is typically adversely affected with slower growth."
4. "…our new data also allow us to see the distinct contribution of public debt overhangs. We find evidence that high levels of public debt matter for the path of economies out of recessions, confirming the results of Reinhart et al. (2012). But the negative effects of high public debt on the performance of the economy arise specifically after financial crises and in particular when private borrowing also ran high. While high levels of public debt make little difference in normal times, entering a financial crisis recession with an elevated level of public debt exacerbates the effects of private sector deleveraging and typically leads to a prolonged period of sub-par economic performance." In other words, not too fast on that champagne, Krugmanites… 
5. "…from a macroeconomic policy standpoint these findings could inform ongoing efforts to devise better guides to monetary, fiscal, and financial policies going forward…" blah… blah… blah… we can stop here.

Funny how no one can get the right idea, though - the reason public debt matters is because the state always has a first call on all resources. As the result, the state faces a choice at any point of deleveraging cycle:

• (A) leverage up the State to allow deleveraging of the real economy; or
• (B) tax there real economy to deleverage the State.

In the US, the choice has been (A) in 2008-2014. In Europe, it has been (B). The thing is: both Europe and US are soon going to face another set of fine choices:

• (Y) reduce profligacy in the long run to deleverage the State; or
• (Z) get the feeding trough of pork barrel politics rocking again.

No prizes for guessing which one they both will make… after all, they did so from 1970s on, and there are elections to win and seats to occupy...

7/2/15: Euro Area's Debt Addiction

Europe's debt addiction in one chart: the following chart plots total domestic and cross-border credit to non-banks, at constant end-Q2 2014 exchange rates, in per cent of GDP:

Source: BIS: http://www.bis.org/statistics/gli/gli_feb15.pdf

In the above:

• The solid lines are actual outcomes, 
• The vertical lines indicate the 2007 beginning of the global financial crisis and the 2008 collapse of Lehman Brothers. 
• Figures include government. 
• The dashed lines reflect long term trend, calculated as for the countercyclical capital buffer in Basel III using a one-sided HP-filter.

Two obvious conclusions emerge from the above:

1. Since the start of the Global Financial Crisis, debt addiction expanded both in the US and the Euro area, with US addiction rising faster than the Euro area's.
2. The gap between Euro area and US dependency on debt at the end of 2014 stood at a similar level as at the start of the Global Financial Crisis and above the pre-crisis level. That is despite the fact that in the US, most recent manifestation of the debt addiction has been associated with much higher economic growth and jobs recovery than in Europe.

1/8/2012: Some interesting notes on Debt and Growth

Some interesting long-term relations between Government debt and economic growth. No comment, but few stats and charts:

First - levels of debt and levels of growth:

Weak, negative relationship above.

Now, rates of change in debt y/y and growth:

Much stronger negative relationship above. Of course, we would expect that negative growth would lead to growth in debt/GDP ratio due to stimuli and due to simple fact of shrinking GDP.

Here's the matrix of average rates:

What do we have?

• Both debt and economy expanding (pro-cyclical expansion): 144 episodes in 1980-2012 period, debt growth on average is 3.172%pa against GDP growth on average of 2.086%pa.
• Recession counter-cyclical growth in debt against contracting GDP: 43 episodes, average growth rate in debt 8.847% and average growth rate in GDP is -2.389%. 
• Countercyclical contraction in debt during economic growth periods: 123 episodes, with average contraction in debt of -2.582% and corresponding (accompanying) expansion in the GDP of 3.782%

So conclusions: during expansions, debt shrinks, but by less than economy grows. During contractions, debt expands but by more than the decline rate in the economy. Worse than that - pro-cyclicality dominates counter-cyclicality. There are more episodes when debt grows during economic expansion than when debt grows during economic contractions. The average rates of debt expansion during economic expansion are greater than the average debt contraction rate during economic expansions. The gap is on average annually of ca 0.6% of GDP in terms of debt growth exceeding debt contraction during episodes of economic growth.

It is worth to note that EA12 are not unique by a significant margin when compared to Advanced economies sample:

16/7/2012: Some charts to illustrate Italian 'disease'

An interesting set of charts on Italian public finances.

First, consider Primary Deficits:

Charts above clearly show that Italy has been running significant primary surpluses since at least 2000 and especially in 2007-2011 period. It is also expected to run strong surpluses in 2012-2017, according to IMF projections.

In fact, net of debt maintenance costs, Italy has outperformed Germany in the area of public deficits in every year other than 2008 and 2009:

Yet, Italy's gross government debt is running over 90% of GDP since 1989 and over 100% of GDP since 1992.

The problem for Italy is clearly on the side of interest payments on its debt:

Although these have moderated during the euro era, the cost is now once again rising.

Italy is but one example of debt overhang that presents long-term problems for the economy. Looking at the set of all advanced economies which experienced more than 5 years periods of debt to GDP ratio in excess of 90%, the chart below shows the relationship between growth rates in real GDP and debt:

Although the explanatory power of the relationship above is weak (ca 10% of variation), the negative relationship between debt to GDP ratio and real growth in GDP is traceable. In terms of averages:

Many caveats go along with the above numbers, but overall, two things are fairly clear: once reached, debt to GDP levels of 85-90% become hard to overcome for many economies, and once debt overhang becomes a problem, growth rates tend to falter.