Gita Gopinath is Professor of Economics at Harvard University. She has worked on debt issues, emerging markets and international economics. Gopinath's RePEc/IDEAS entry.
- EconomicDynamics: The current crisis with Greece and possibly other European countries highlights that it has become more difficult to manage high public debt when currency devaluation is not an option. Aside from drastic austerity measures, what are possible policies?
- Gita Gopinath: The interaction between high public debt and the inability to devalue has come up frequently in discussions of the Euro crisis. However, there is an important distinction to be made. There are two channels through which a currency devaluation can help a government repay its debt: One, by reducing the real value of the debt owed and two by stimulating the economy through adjustments of the terms of trade and therefore raising primary fiscal surpluses for the government. The first channel is relevant to the extent that the debt is denominated in local currency in which case the real value of debt owed externally is lower. However, in the case of an individual country in the Euro Area like Greece whose debt is in Euros, even if they were to exit the Euro, as long as they did not default on their debt contracts by re-denominating their liabilities in their local currency, a currency devaluation would do little to reduce the value of debt owed.
As for the second channel through which a currency devaluation can help, namely the expansionary effect it can have on economic output, there is a clear substitute through the use of fiscal instruments. In a recent paper, Farhi, Gopinath and Itskhoki (2011) show that "fiscal devaluations" deliver the exact same real allocations as currency devaluations. Currency devaluations to the extent they have expenditure switching effects do so by deteriorating the terms of trade of the country, that is raising the relative price of imported to exported goods. In the absence of a currency adjustment, a combination of an increase in value added taxes (with border adjustment) and a uniform cut in payroll taxes can deliver the same outcomes. An increase in VAT will raise the price of imported goods as foreign firms face a higher tax and it will lower the price of domestic exports (relative to domestic sales prices) since exports are exempt from VAT. The net effect is a deterioration in the terms of trade equivalent to that following a currency devaluation. To ensure that firms that adjust prices do so similarly across currency and fiscal devaluations an increase in VAT needs to be accompanied with a cut in payroll taxes. We show that the equivalence of currency and fiscal devaluations is valid in a wide range of environments, with varying degrees of price and wage stickiness and with alternative asset market structures.The increase in VAT can be viewed as an austerity measure but it is important to note that when combined with a payroll tax cut its impact on the economy is exactly the same as that following an exchange rate devaluation. In other words the lack of exchange rate flexibility does not limit the ability of countries in the Euro area to achieve allocations attainable under a nominal exchange rate devaluation.
- ED: In the face of the latest debt developments, central banks have been much more proactive than historically. Do you view this as a good development?
- GG: The European Central Bank has certainly been proactive in containing the debt crisis in Europe through direct purchases of troubled sovereign debt. At the same time they have been cautious in their role of lender of last resort. Their current stance is that they are not willing to monetize the debt of countries at the risk of future inflation. Given that the crisis has spread to Italy and to a lesser extent France it will be interesting to see how the ECB responds.
The bigger question is what should a central bank do. Should it stick to its mandate of targeting inflation or should it resort to inflating away the debt so as to prevent a default by the country? I do not believe we have the answers here. As recently pointed out by Kocherlakota (2011) if a central bank decides to commit to an inflation target then this effectively makes the debt of the country real. The country can be subject to self-fulfilling credit crisis along the lines of Calvo (1988) and Cole and Kehoe (2000). If lenders expect that governments will default they raise the cost of borrowing for governments who then find it difficult to roll over their debts and this in turn triggers default. The negative consequences for the economy of a default are potentially large.In this context suppose a central bank is willing to inflate away the debt. Does this firstly rule out the multiple equilbria described previously? Calvo (1988) evaluates several scenarios some of which involve multiple equilibria even when default is implicit through inflation. So it is not obvious whether having the ability to inflate solves the multiplicity problem. Then there are the relative costs of inflation versus outright default. A plus for inflation is that it can be done incrementally unlike default that is much more discreet. It is arguable that the costs of a small increase in inflation are low relative to the costs of default. Of course the level of inflation required can be very high and this can unhinge inflation expectations that then can have large negative consequences for the economy. So, as I said earlier, it is still to be determined in future research what the virtues are of having a central bank that uses its monetary tools to contain a debt crisis.
- ED: While it is always an economic solution to a threat of default, political constraints are very restricting, as Greece shows. Are we neglecting the political economy aspects?
- GG: It is not straightforward even from a pure economic point of view. Should countries default or undertake austerity measures to remain in good credit standing? The answer depends on how costly defaults are and empirical evidence on this provides little guidance. In our models we postulate several costs associated with defaults, including loss of access to credit markets (Eaton and Gersolvitz (1981), Aguiar and Gopinath (2006)), collateral damage to other reputational contracts, spillover to banking crisis, trade sanctions etc. See Wright (forthcoming) for a non-technical survey of the sovereign debt and default literature. The empirical evidence on this, as surveyed in Panizza et al. (2009) is, however, not very informative given the endogeneity of defaults. The ambiguity associated with the optimal response to the debt crisis was evident at the start of the debt crisis in Europe when there was little agreement even among economists about whether Greece should default or not.
Then, as you rightly point out the political economy aspects add another dimension of complexity. The political constraints have permeated all aspects of the debt crisis. Firstly, the objective function being maximized here is clearly not purely based on economics but based on political factors that motivated the formation of the Euro. Secondly, the policy responses have been constrained by politics. For instance, at the start of the crisis it was widely perceived that the reason the Germans and French were interested in bailing out Greece was mainly to protect their banks that had significant exposure to Greek debt. An alternative, less costly route was to directly bailout German and French banks but that was viewed as politically impossible to implement. The Euro zone is now back to where it started with banks needing bailouts, except the crisis has exacerbated with now the debts of Portugal, Spain and Italy also facing default pressure. In addition, the political fallout of implementing austerity measures is evident all over Europe.While there exists a large literature on the political economy of sovereign debt the focus has largely been on explaining why a country can end up with too much debt. There is more limited work that combines political economy with the possibility of sovereign default. An exception is Manuel Amador (2008) who examines the role of political economy in sustaining debt in equilibrium and Aguiar, Amador and Gopinath (2009) who show that the relative impatience of the government combined with its inability to commit to repayment of debt and its tax policy can lead distortionary investment cycles even in the long-run. There is almost no work on the redistributional impact on heterogeneous agents of the decision to default versus to undertake costly austerity measures, something the current crisis has brought to the forefront. This is certainly fertile ground for future research.