After the Fall with Carmen Reinhart - Economics Roundtable

this UCSD TV program is a presentation of University of California television for educational and non-commercial use [Music] only [Music] what my aim uh is to touch upon various issues dealing with debt debt is the unifying theme uh of my talk and it encompasses pretty much all my uh research uh since the this time is different book and let me sort of highlight the three areas that I'm going to touch upon uh the first uh which is in decade of debt uh the short uh book that that Ken and I just put out uh has to

do with a sequencing and the time profile of Crisis so essentially how does a crisis unfold and specifically where are we in that process uh the second theme of my talk is literally after the fall after the fall is a research piece that I did with Vincent Reinhardt my husband for the Federal Reserves Jackson hle conference last year the third theme and final theme that I'm going to touch on today is uh ongoing work which is the uh my my most recent and ongoing uh research work with a student of mine at the University of

Maryland uh Mari Aben brania on a paper called the liquidation of government debt and essentially that has brought forward or has renewed uh in the public jargon the term Financial repression and basically uh why that is relevant is because it has to do with that theme of the resolution of Crisis um some of the as as I will speak on later the most extreme forms of Crisis resolution involve explicit restructuring uh if not outright default on debt that's the most extreme cases and that's what we're seeing where I came from and yesterday in the European

context but part of the resolution and this is just sort of anticipating where I'm going I'm giving the road map uh part of uh the resolution to the big bulge in government debt at the end of World War II involved Financial repression what is financial repression in a nutshell Financial repression involves a tighter connection between government and the financial industry uh the outcome is much more heavy-handed regulation but the bottom real bottom line is very low or even negative real interest rates uh which and more directed credit to the government uh which is sort of

the logical thing that you would think that a government that has a lot of debt and that worldwide appetite for debt uh is somewhat diminished in the private sector and so creative regulatory mechanisms arise to place those debts at very low interest rates and I will so so and part historically part and parcel of financial repression as I said involved elements of direct more directed credit uh elements of suppression of interest rates uh by the way operation twist is also Not A New Concept it's we we're dusting off a lot of old things these days

um and more elements of international barriers to Capital movements I.E the bad word is capital controls of course today we're not calling them Capital controls we're calling them macroprudential regulation um so so that's the road map um and then hopefully you know uh we can have a nice discussion afterwards uh let me briefly start with the time profile so think of a flowchart of how these crisis evolve and how they mature in the initial phase you have some sort of financial liberalization Financial innovation in the US the big item was the subprime the securitization of

mortgage debts now during that Financial liberalization period the financial Innovation period credit is very ample credit is relatively cheap uh and we're all Geniuses in that period it's it's asset prices boom uh economic activity performed strongly and during that boom phase Leverage is built up significantly this is private leverage usually I will talk about the Greek situation and the Italian situation also which are are somewhat different from this pattern but this is the most common pattern that is revealed in history we have we have that in our book and we also have that in our

in our recent uh American Economic Review paper after the fall I mean um from financial crash to debt crisis and so during that boom period asset prices uh and credit expansion uh ultimately end as they have ended for you know not decades but hundreds of years badly uh so a financial crisis a banking crisis ensues now the banking crisis does two fundamental things to morph itself into a sovereign or fiscal crisis uh Financial crises are associated with very protracted and severe recessions they're not your run-of-the-mill recessions that you overcome quickly uh and we've been saying

this uh Ken rogoff wrote and I wrote a paper called um the aftermath of financial crisis we presented it at the American economic Association meetings in January of 2009 saying this is not a standard recession the leveraging is a long process and so it it and and and the bottom line of those deep and protracted recessions is that government revenues take a severe hit so fiscal finances even without any fiscal stimulus or anything else and we have experts on fiscal stimulus uh in this room but even without that you get a big negative shock to

fiscal finances now you throw on top of that this is a key point that since World War II this was not the case in Pre World War II financial crisis but in post World War II financial crisis the blur there's a blur between what is private debt and public debt that is what are private debts before the crisis become public debts afterwards the most extreme case of that is Ireland Ireland had debt to GDP of 30% by any metric it had an incredibly tight ship on the fiscal side now Ireland's finances are pushing on Italy

and will probably overtake Italy not because the government had a Greek style chronic problem of overspending and and inability to raise revenues but because they took on massive amounts of Bank debt in the US we had Fanny and Freddy in 2010 Fanny and Freddy were shifted if you look at the flow of fund statistics from the uh Federal Reserve in in in 2010 The Fanny and Freddy were shifted from the private sector balance sheet to the public sector balance sheet that transfer was 25 percentage points of GDP so so the general government debt in the

United States General government includes federal state and local and government Enterprises and Fanny and Freddy became a government enter price and that added 25 percentage points in one shot to our general government debt so between the ass between the government taking on private and this is continuing in Europe okay let me say that this is not an academic uh point that I'm making this is as we speak Europe is poised for another major round of bank recapitalization and in English bank recapitalization will mean that those Debs that are now in the hands of the banks

will end up in the balance sheet of the government uh and so this process of the the the the blurring of the lines between P private debt and public debt is still ongoing uh my expectation is that we still have some of that in the future ahead of us uh in the United States with the completely unresolved mortgage uh that overhang uh that we that we have so the sequence is the financial crisis morphs into a fiscal crisis and that's where we are now the FIS how do how do we how do we get out

of that uh and this so what happens after the financial crisis became a fiscal crisis well there are uh different possibilities of bringing down public debts one is you lock out and you grow a lot very rare historically really really rare So if you look for example at cases where you can say now that economy just grew its way out of its debt you got Ireland essentially in the 1980s in which you know the Ireland of the early 80s had a government uh with debt over 100% And then just incredibly rapid growth Whitted that debt

down pretty sharply but that's that's an outlier most often countries do not grow their way out of debt growth contributes growth contributed importantly after World War III but it was definitely not the sole Factor so then the second item is austerity uh and you have fiscal austerity not because you know I am not one of these Believers in that fiscal austerity is actually expansionary uh certainly not contemporaneously uh fiscal austerity is austerity it has you know uh um short-term effects that are are are contractionary even though it's the medicine you need to take it's like

when I go to the doctor I says Carmen look you know if you want to lose weight you got to exercise and diet and I said look unfortunately I want to lose weight but I don't want to exercise and diet uh and and and that's you know um but that's essentially you know without being factious or anything but that is fiscal austerity it you know you you're you're trading intertemporally okay um so if you look at the very sharp debt reductions after World War II also you see the US ran balanced budgets for extended periods

of time you see you know components of fiscal austerity fiscal discipline if not outright austerity okay um then you have in the most extreme cases the very controversial issue that Europe is tackling right now is the issue of debt restructuring so this is in this I'm in in that time sequence I'm now talking about my second item on the agenda which is how do you get out of this debt resolution um restructuring uh you know we seem to think that oh no that's something that happens in Latin America that's something that happens in Africa it

happens in Asia it doesn't happen in Europe wrong if you look from and and this is documented in our work just turn to the page in in the decade of debt look at the pce page on Greece from Greece gained independence in 1830 and since 1830 Greece has been in a state of defa or restructuring 48% of the years okay so the last restructuring episode for Greece began in the depression in 1932 but only concluded in 1964 when the final debts expired that unpaid debts expired okay so the the thought that we are this is

uncharted waters this is advanc no no no uh this is this is an old story a lot of the advanced economies saw restructurings either very explicit or more under the rug Variety in in in the Depression years we just forgotten we live in a postor war II framework were the only ones that had defaulted in that new default I mean in the postwar War II uh framework were the emerging markets that was not always the case and we're revisiting that proposition very seriously now in my own view the debts of Greece Ireland and Portugal will

have to be restructured for different reasons Greece uh has you know and this is not by the way oh no you mean that they can do restructuring and not have to do austerity no this is not in Li of because if you don't don't do the austerity you're going to have primary uh fiscal deficits and you're going to wind up in the same place pretty quickly but it it let's do the math you have nominal debt to nominal GDP nominal GDP has two components one is growth and the other one is inflation I I don't

Envision most of Europe becoming Singapore or you know East Asia overnight in terms of you know SU Ain high levels of growth they're they're they're they're not that's not a probable scenario I don't Envision Europe using full-blown inflation to liquidate its debts so if you really have limited scope for expanding the denominator nominal GDP you're going to have to work on the numerator which is debt and in the case of Greece it is a fiscal problem it is predominantly a fiscal problem private debts are are problematic but they're not of that order of magnitude case

of Ireland is extremely unfortunate but it's a different animal this is not people think I'm being melodramatic when I I I make this statement but I am not this is data from the World Bank and IMF joint um their sdds standard data dissemination system quarterly data reveals that gross external debt this is public all public plus all private external debts in Ireland are over 1,000% of GDP 10 times GDP only Iceland matches has historically matched that number I mean I I this data that I have is in the public domain this is not with the

sources and the whole time series so so in the case of Ireland it's not policy and decisiveness it's not the inability of the government to to to move very quickly in the right directions they've done very courageous things but they started they started with the scale of a problem so the only way that in my view Ireland avoids a restructuring is if it doesn't require further recapitalization of banks but I don't think that's in the cards right now as I said the gross external debt numbers are over a th% of GDP and the deposits in

countries like Greece and Ireland are not declining they are bleeding uh Bank deposits are draining they're being shifted you you have Capital flight this is you know anyone that looked at Latin America in the 1980s knows this all too well cap plain plain Capital flight uh that leaves banks in a even more precarious situation CU you're they don't have access to International financing their domestic deposit bases eroding and they still have these unresolved assets so what I am getting at is for for reasons pertaining to the weakness extreme weakness of the banking sector I think

Ireland will end up restructuring its its its debt as well uh Portugal uh Portugal in a benign scenario has current account deficits for the year 2013 between a 9 and 10% of GDP now this is just accounting if you have a current account deficit you need a capital account Surplus IE you need to finance that current account deficit because you're borrowing from the rest of the world and you ask who's going to lend to Portugal it's not the private sector they would need funding from the ECB and from the efsf to be able to continue

so uh this brings me to the conclusion that these three countries for different reasons are going to wind up in the extreme case of restructuring let me say a couple of things about growth expectations uh unemployment expectations and turn to my final uh commentary on financial repression so in the extreme cases which I right now ring fencing would seem to be those three uh Greece Ireland and and and Portugal Italy and Spain are there on the brink there's a huge I mean to say that that that the sense of outright fear that you get talking

to people in Italy is is an is not not an overstatement um because again for different reasons Italy because of its public finances but they don't have much private debt to to they didn't have the big debt surge before the crisis and Spain not because of its fiscal finances so much because they still have f School space but they really haven't resolved their banking sector problem yet which is going to be more cost to the government uh or also in that borderline where I don't think they'll need to restructure but this is a you know

they're they're in the borderline what about the US right what about uh what about the US what about the UK what about what about well in the paper after the fall um we pointed out and this I spoke at Jackson Hall right before chairman Bernan this was not this August but the August before and chairman banki had given a fairly uplifting uh um assessment of the US economy and I said look you know I our our work shows here that for the ad these are for the crisis and the advanced economies Vincent and I you

know separated out we did all the crisis together then we separate out Advanced economy crisis from Emerging Market crisis for the the decade after the crisis growth is about one percentage Point slower in so it's it's not about negative growth it's we're not saying that oh this double dip is inevitable that you know the end of the world it's not about it is about a muddling through scenario it is not you know the end of the world world and the apocalypse and biblical and and you know but it is about not having as a framework

the 10 years before the crisis okay that is not uh the the likely or probable scenario because during that decade after after the fall one of the common currents in all these we have 15 different crises there five of them from advanced economies the years after the financial crisis have different monetary policies different fiscal policies different exchange rate outcomes but the Common Thread is private sector deleveraging in all of those and getting rid of the private debt overhang and that on average takes about seven years in this sample for some countries like Japan it took

longer for other countries in Scandinavia they were able to Short Circuit at the process okay but it is a dampening influence on growth so it's a subpar growth it's not about a collapse or anything but it's a subpar growth environment the most alarming statistic we had was that unemployment rates in the decade following severe financial crisis actually remain about 5 percentage points higher than in the decade before the crisis so unemployment rate are very so we our low point was four okay so that's if this is using the mechanical calculations based on the averages and

the the descriptive uh data that we have that means a very stubbornly high unemployment rate I'm not making a prediction I'm saying that you know if you look at this data in 10 of the 15 cases unemployment did not return to its pre-crisis is low in a full decade it's it's again not it's a lingering Pro you know it's a lingering slow recovery um and and this doesn't mean that you have quarterly Sparks here and there that look great that is actually a you know you know Japan had uh some really exciting quarters in the

in in in the in the 1990s just before the Asian crisis uh uh produced another round of downturn let me now turn to my last issue so so how again if assuming that you do have fiscal austerity of varying degrees in the US and elsewhere the timing again is we can discuss that on the Q&A and my expectations is a that fiscal austerity or you know a shift towards bance budgets is is is in the offing um assuming that you don't have growth collapses so that you do get some benefit from growth and from positive

inflation to reduce the debt what was the third element in postor War II advanced economies because when I use the term Financial repression people say oh no no no that's China That's India no no that was the us and that was the UK after World War III you know I am probably older than many of you not all of you uh but uh uh you know uh that we had regulation Q which caps deposit rates uh at zero for checking accounts and kept them extremely low until the early 80s uh that was one example of

financial repression um think of this chart that I'm about to describe it is a chart that has three okay it is a chart for real in that is treasury rates adjusted for inflation so it's real interest rates inflation adjusted interest rates for 21 advanced economies and I have three lines in that chart frequency distributions from 1945 to 1980 from 1981 to 2007 and from 2008 to the present the upshot between 1945 and 1980 real interest rates on treasuries were negative about almost half of the time about 49% of the time the era of financial liberalization

you know we got rid of of glass ego we got rid of Regulation Q uh Capital markets became Global 802 2007 real interest rates were negative less than 10% of the time since the crisis since 2008 interest rates in the advanced economies have been negative 52% of the time uh so the issue of financial repression has resurfaced in you go to Italy you go to Greece you go to Ireland Portugal the you the debts of the government are literally through moral suasion being shoved down the banks and the Pension funds these are the captive audiences

you you you so Financial repression really is about doing what the Japanese have done extremely well which is going after captive audiences placing your debts domestically and the targets the most obvious targets are Pension funds insurance companies and Banks and if you look at the IMF data this is nothing that I put together but the IMF Capital markets group does this and you look at the share of government debt that's in the balance sheet of Greek Banks that's in the balance of UK Banks that's in the balance of Irish Banks all those we have become

more increasingly uh home biased in our investments and not all of this is voluntary uh um Bas it's not all you know I look I am not expecting I will conclude by saying I am not expecting the financial repression Act of 2012 okay that's not what I'm talking about I am talking about regulations that if you read the footnotes here and there uh start introducing more barriers more um the Emerging Markets have raised uh all kinds of varieties of capital controls and they have done so with the approval of the International Community and the IMF

and in the advanced economies we need to keep capital in the Emerging Markets want to keep some of that hot money out and I think the the not in a big bang way but in a sort of footnote way we are moving we're going through the cycle of from Full liberalization to more financial controls and that I think is is is the where where the next cycle is taking us and I'll conclude [Applause] [Music] [Applause] [Music] there [Music] oh [Music]