1

Superstars of macroeconomics

1

Irving Fisher, Yale(1867-1947)

James Tobin, Yale(1918-2002)

Milton Friedman, Chicago(1912-2006)

Robert Mundell, Columbia(1932 - )

J. M. Keynes, Kings College(1883-1946)

Janet Yellen, the Fed(1946 - )

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Debts and DeficitsLast time:- Conceptual issues of debts and deficits- Deficits and slower growth of potential Y in the closed

economy- Role of deficit spending in recessions, particularly in the

liquidity trap

Today:- To raise or lower G in recessions, Europe and US today?- The death spiral of debt and default

Two Views of the Great Unraveling (I):Soft Landing

The two faces of saving and the deficit dilemma

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What are the effects of deficit reduction on the economy?

1. In short run: • Higher savings is contractionary • Mechanism: higher S, lower AD, lower Y (straight

Keynesian effect)

2. In long-run:• Higher savings leads to higher potential output • Mechanism: higher I, K, Y, w, etc. (neoclassical growth

model)

Dilemma of the deficit: Should we raise G today or lower G?

Real output (Y)

Inflation

AD

AS’Impact of fiscal stimulus

AS

AD’

?

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The dilemma of the deficitTo illustrate, I use a little simulation model built from our

five equation IS-MP model plus a Solow growth model.

Then compare(1) a large stimulus program to reach full employment(2) a balanced budget program

Use historical data, calibrated model, and “plausible” projections of variables.

     

       

     

1. Demand for goods and services:        *2. Business real interest rate:         –         3. Phillips curve:    4

bt

b et t

et

t t t

t t t t

t t t

y r Gr i r

y

  1

       

     

. Inflation expectations:                 5. Monetary policy:      *   *  

6. Potential output: 

(

  [

)

, (

et

pott

t

t t t Y t

t t t

i r y

Y A F K LF

1 *)]u

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Stimulus v. balanced budget in 2012

- Balance budget in 4 years (EU style austerity)

- Stimulate to reach FE in 3 years (Krugman style superstimulus)

- Assume that 50% of public dissaving is offset by private saving.

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Actual deficits: ½ trillion a year

-1,600

-1,400

-1,200

-1,000

-800

-600

-400

-200

0

2002004 2006 2008 2010 2012 2014 2016 2018 2020

Defi

cit (

billi

ons

of $

)

Krugman Deficit Balanced Budget Deficit

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The long-term debtHave higher debt-GDP ratio for long time

0

10

20

30

40

50

60

70

80

902004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026

Debt

-GD

P (%

of G

DP)

Krugman Debt-GDP Balanced Budget Debt/GDP

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But the economy pays the price in high U

- With fiscal austerity, have long period of stagnation.

0

2

4

6

8

10

12

142004 2006 2008 2010 2012 2014 2016 2018 2020

Perc

ent

Krugman U rate Balanced Budget U rate

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Lower potential with stimulusSlower growth in potential with stimulus because the debt

causes lower capital stock

10,000

12,000

14,000

16,000

18,000

20,000

22,000

24,000

26,000

28,000

30,0002004 2009 2014 2019 2024 2029 2034 2039 2044

Pote

ntial

GD

P ($

bill

ions

)

Krugman Potential GDP Balanced Budget Potential GDP

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Cumulative Difference in GDPBecause of recession, balanced budget doesn’t make it up in a

generation, even without discounting.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%2004 2009 2014 2019 2024 2029 2034 2039 2044

Perc

ent o

f GDP

Cumulative Diff Krugman-BalBud (% GDP)

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Conclusions on Debt and Deficits• Central long-run impact of fiscal policy is on

POTENTIAL output through impact on national savings rate.

• But in deep recessions, particularly in liquidity trap, need larger deficits to stimulate ACTUAL output reach full employment.

• So policy needs differ in recession and full employment.

Economics of External Debts

American Econ Review, August 2011. Also see their book, This Time is Different..

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Misinterpretation by Deficit Commissioner

“When the markets lose confidence in a country, they act swiftly and they act decisively. Look at Greece, look at Portugal, look at Ireland, look at Spain.* If they markets lose confidence in this country and we continue to build up these enormous deficits and debt, they will act swiftly and decisively.”

[Erskine Bowles, Chair, President’s Commission]

* BTW: This is completely wrong analytically.

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Defaults and restructuring are endemic• Default: A sovereign default is defined as the failure

to meet a principal or interest payment on the due date (or within the specified grace period).

• These are often called “restructuring” or “repudiation” but have the same effect.

Reinhard and Rogoff, From Financial Crash to Debt Crisis, AER, 2011

Fiscal deficits plus loss of confidence pushes over the tipping point to where cannot refinance debts

Country fiscalposition

Rising risk premium and interest burden

REVIEW: Romer debt modelBasic ideas:- This is the run on the bank as applied to countries.- Basic idea is that have an instability because of the

impact of risk on country interest rates (rd = rw + σ).- Two equilibria: good (full employment) and bad (default)Assumptions:- Government has debt of D and default probability π.- Governments have a random tax revenue, T, with cdf

F(T).- Interest:

- When T < RD, the government defaults

( ) ( ), where ri1 (1 ) 1- sk-free1- rat =( ) /

e.RR RR r r r

R

REVIEW: Math of Romer model- Investor equilibrium:

- Government default occurs when T < RD, which has a cdf (cumulative distribution function):

- We have two equilibrium equations in R and π.

( ) /R RR

( )F RD

π(prob. ofdefault)

Governmentand taxes

1

R (interest factor)0

Investors

R

REVIEW: Three equilibria

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Simplified Romer model- Investor equilibrium that R = (1+rd) determined by prob of

default:

- Assume for simplicity that taxes (T) are known with certainty to be T*. So government default occurs when T < RD:

- We have two equilibrium equations in R and π.

/ (1 )RR

1, when < 0, when >

T RDT RD

With adequate revenues, likely to have good equil.

π(prob. ofdefault)

Governmentand taxes

1

R (interest factor)0

Investors

R

π(prob. ofdefault)

Governmentand taxes

1

R (interest factor)0

Investors

R

With low revenues, multiple equilibrium with bad outcome

EZ interest rates

Examples of unstable equilibria

The unfortunate weak currencies in the EZ

Spain and UK had virtually same deficit and fiscal position in 2010.

0

1

2

3

4

5

6

7

820

07-0

1-01

2007

-04-

01

2007

-07-

01

2007

-10-

01

2008

-01-

01

2008

-04-

01

2008

-07-

01

2008

-10-

01

2009

-01-

01

2009

-04-

01

2009

-07-

01

2009

-10-

01

2010

-01-

01

2010

-04-

01

2010

-07-

01

2010

-10-

01

2011

-01-

01

2011

-04-

01

2011

-07-

01

2011

-10-

01

2012

-01-

01

2012

-04-

01

2012

-07-

01

2012

-10-

01

UK

Spain

Interest rates on sovereign debt

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What can the EU do?1. Fiscal austerity, but with great economic cost.2. Guarantee debts, but this involves north-south

transfer.3. ECB buy bad debt, but moral hazard and hidden

transfers.4. Break up Eurozone, but this has untold economic

perils.

[See discussion in earlier class.]

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Does this apply to the US?Country type 1: What is the historical frequency of

foreign debt crises for countries with either fixed exchange rates or debts denominated in external currencies a la Greece, Italy, Spain, Argentina, etc.?

Answer: average of 14 every year for last two centuries.

Country type 2: What is the historical frequency of foreign debt crises for countries with flexible exchange rates and debts denominated in their own currency? E.g., US.

Answer: I could not find one.

Why? Because country type 2 can print money ($). Problem is inflation or hyperinflation, not debt crisis.

Final wordsYou have heard of the “hard sciences.” But macro is a “very hard science.” Why is it so challenging? Listen to the conversation between Keynes and the revolutionary physicist, Max Planck, that took place at high table in King’s College, Cambridge:

“Professor Planck, of Berlin, the famous originator of the Quantum Theory, once remarked to me that in early life he had thought of studying economics, but had found it too difficult!

“Professor Planck could easily master the whole corpus of mathematical economics in a few days.

“But the amalgam of logic and intuition and the wide knowledge of facts which is required for economic interpretation in its highest form is overwhelmingly difficult.”