structural reforms in a debt overhangstructural reforms in a debt overhang javier andrØs1, Óscar...

Structural Reforms in a Debt Overhang

Javier Andrés1, Óscar Arce2 and Carlos Thomas3

National Bank of Belgium, June 18 2014

1Universidad de Valencia, Banco de España2Banco de España3Banco de EspañaAndrés, Arce & Thomas () Reforms in a Debt Overhang

National Bank of Belgium, June 18 2014 1/ 34

Motivation (I)

High levels of private debt and need to deleverage act as a drag ongrowth in the EMU periphery

Andrés, Arce & Thomas () Reforms in a Debt OverhangNational Bank of Belgium, June 18 2014 2

/ 34

Motivation (II)

In the short term, little room for

fiscal policy (large deficits)(conventional) monetary policy (ZLB).

Much of the focus is on structural reforms, mainly in product andlabor markets.

Most offi cial views (e.g. OECD, IMF, ECB) support reforms.

Reforms are clearly positive in the long run, but their short/mediumterm impact is less well understood.

EMU periphery conditioned by high debt cum slow private-sectordeleveragingThis paper: study impact of structural reforms in an environment ofslow deleveraging


/ 34

Framework

DSGE model, small open economy inside monetary union

Lenders & borrowers, collateral constraints à la Kiyotaki & Moore(1997). As in Iacoviello (2005), real estate is the only collateral.

Key point of departure: long-term debt ⇒ double debt regime:

a) In normal times: debt restricted by value of collateralb) In crisis times: no new credit, debt amortized slowly

Baseline deleveraging scenario: negative shock to LTV ratios (’creditcrunch’)⇒ economy enters regime (b): slow and protracted deleveraging

Time of change from regime (b) to (a), i.e. end of deleveragingphase, is endogenous


/ 34

Preview of results

Structural reforms (reductions in desired price & wage markups)boost output in long run (as expected), but also in short run.

Particularly true for product market reform

Brings forward the (endogenous) end of deleveraging phase/recession

Labor market reform creates modest short-run gains

Double layer of nominal rigidities (wages and prices) delaysimprovement in price competitivenessBroader reform (including higher wage flexibility) generates sizableshort-run gains

Long-run debt weakens negative Fisherian debt deflation effect(becomes second order)


/ 34

Recent literature

Some recent work on the impact of reforms:

Eggertsson, Ferrero & Raffo (2014):

if monetary policy is at ZLB, deflationary structural reforms increasereal interest rate → depress aggregate demandthis channel may dominate positive income effect (from long-run gains)in the short run

Galí & Monacelli (2013): short-run effects of wage moderation(through lower payroll taxes) is small if no monetary accommodation

Fernández-Villaverde, Guerrón-Quintana & Rubio-Ramírez (2012):

credible announcement of future structural reforms triggers gainsalready in the short-run (positive income effect)BUT no deflationary effect on impact

None of these papers study effects of reforms in a scenario of slowdeleveraging


/ 34

Model structure

Small open economy in a monetary union⇒ monetary policy exogenous ≈ ZLBThree consumer types

Patient households (lenders)Impatient households (borrowers)(Impatient) entrepreneurs (borrowers)

Three production sectors

Consumption goods (entrepreneurs + retailers)Equipment capital producersConstruction

Trade with rest of world: consumption goods and foreign debt

Standard real and nominal frictions: investment adjustment costs,nominal price and wage rigidities


/ 34

Impatient households

Maximize

E0∞

∑t=0

βt

{log (ct ) + ϑ log ht − χ

∫ 1

0

nCt (i)1+ϕ

1+ ϕdi

},

subject to

ct + pht [ht − (1− δh) ht−1] = bt −Rt−1πt

bt−1 +∫ 1

0

Wt (i)Pt

nCt (i) di .

and an asymmetric debt constraint...


/ 34

Asymmetric debt constraint

We assume long run debt

A constant fraction 1− γ of nominal outstanding principal isamortized each period (Woodford, 2001)

Dynamics of real outstanding debt,

bt =bt−1πt

+ bnewt − 1− γ

πtbt−1 =

γ

πtbt−1 + bnewt .

bnewt : gross new credit

If collateral value < γ bt−1πt, setting bt = collateral value would require

bnewt < 0 ...

... but debtor cannot be forced to pay back faster than 1− γ; hencebnewt = 0.


/ 34

Asymmetric debt constraint (cont’d)

This implies a double debt regime:

in ’normal’times, borrowing is restricted by expected discounted valueof collateral,

1RtmtEtπt+1p

ht+1ht ,

mt : exogenous loan-to-value (LTV) ratiowhen collateral values fall below contractual amortization path,γbt−1/πt , the latter becomes the effective debt limit

Formally,

bt ≤{

1RtmtEtπt+1pht+1ht ,

1RtmtEtπt+1pht+1ht ≥ γ bt−1πt

γ bt−1πt, 1

RtmtEtπt+1pht+1ht < γ bt−1πt


/ 34

Entrepreneurs

Maximize

E0∞

∑t=0

βt log cet ,

subject to

cet + pht [h

et − (1− δh) h

et−1] + qt [kt − (1− δk ) kt−1]

= mcty et −Wt

Ptnet + b

et −

Rt−1πt

bet−1 + ∑s=r ,h,k

Πrt ,

y et = Atkαkt−1 (h

et−1)

αh (net )1−α−αk ,

bet ≤{

1Rtmet Etπt+1p

ht+1h

et ,

1Rtmet Etπt+1p

ht+1h

et ≥ γe

bet−1πt

γebet−1πt, 1

Rtmet Etπt+1p

ht+1h

et < γe

bet−1πt

.


/ 34

Calibration

We target key ratios of the Spain in 2007:

Ratio Data (%) Model (%)construction share of GDP 12.45 15.11construction share of employment 13.39 15.44labor share of GDP 61.59 64.84corporate debt / annual GDP 125.36 128.85household debt / annual GDP 80.22 79.94net foreign debt / annual GDP 79.3 79.3gross exports / GDP 26.9 26.9


/ 34

Calibration (2)

Parameters not pinned down by targets are set to standard valueswithin NK-DSGE literature

Parameters affecting debt constraints

LTV ratios: households m = 0.85, entrepreneurs me = 0.71Amortization rates: households 1− γ = 0.02, entrepreneurs1− γe = 0.04⇒ average debt maturity: 1/ (1− γ) = 50, 1/ (1− γe ) = 25 qrts


/ 34

Baseline scenario: a deleveraging shock

We simulate a deleveraging shock for entrepreneurs and constrainedhouseholds:

Gradual, permanent fall (10pp) in loan-to-value (LTV) ratios: mt , met


/ 34

Deleveraging shock: LTV ratios

0 10 20 30 40 50 600.75

0.76

0.77

0.78

0.79

0.8

0.81

0.82

0.83

0.84

0.85LTV households (m)

quarters0 10 20 30 40 50 60

0.6

0.62

0.64

0.66

0.68

0.7

0.72LTV entrepreneurs (me)

quarters


/ 34

Deleveraging shock: regime changes

0 10 20 30 40 50 60

8

10

12

14

16

18

quarters

Entrepreneur debt

γebet1/πt

met ph

t+1πt+1het /Rt

bet

T*

0 10 20 30 40 50 602

4

6

8

10

12

14

quarters

Household debt

γbt1/πt

mtpht+1πt+1ht/Rt

btT**


/ 34

Baseline scenario: a deleveraging shock

Large initial shock and asymmetric debt limits produce a doubleregime change:

For t = 1, ...,T ∗, value of entrepreneurs’collateral falls belowγebet−1/πtFor t = 1, ...,T ∗∗, value of households’collateral falls below γbt−1/πt

γe < γ⇒ T ∗ < T ∗∗: faster amortization of entrepreneurial debt

Dates of regime change T ∗ and T ∗∗ are solved endogenously


/ 34

Deleveraging shock: macroeconomic effects

0 20 40 6010

5

0

5GDP

quarters

%

0 20 40 6010

5

0

5employment

quarters%

0 20 40 6040

60

80

100household debt / GDP

quarters

pp

0 20 40 6080

100

120

140entrepreneurial debt / GDP

quarters

pp

0 20 40 6010

5

0

5real estate prices

quarters

%

0 20 40 6030

20

10

0total investment

quarters

%

0 20 40 606

4

2

0

2total consumption

quarters

%

0 20 40 602

1

0

1CPI inflation

quarters

annu

aliz

ed p

p

0 20 40 606

4

2

0real wage

quarters

%

0 20 40 601

0

1

2exante real interest rate

quarters

annu

aliz

ed p

p

0 20 40 602

1

0

1

2terms of trade

quarters

%

0 20 40 6050

0

50

100net exports

quarters

%Andrés, Arce & Thomas () Reforms in a Debt Overhang

National Bank of Belgium, June 18 2014 18/ 34

Deleveraging shock: long vs short-term debt

Long run debt produces a more realistic deleveraging path and (critically)allows for endogenous regime change

0 20 40 6020

10

0

10GDP

quarters

%

0 20 40 6030

20

10

0

10employment

quarters

%

0 20 40 6020

40

60

80


quarters

pp

0 20 40 6080

100

120


quarters

pp

0 20 40 6010

5

0

5real estate prices

quarters

%

0 20 40 6030

20

10

0total investment

quarters

%

0 20 40 6030

20

10

0

10total consumption

quarters%

0 20 40 604

2

0

2CPI inflation

quarters

annu

aliz

ed p

p

0 20 40 606

4

2

0real wage

quarters

%

0 20 40 601

0

1


quarters

annu

aliz

ed p

p

0 20 40 602

1

0

1

2terms of trade

quarters

%

0 20 40 60200

0

200

400net exports

quarters

%

longrun debtshortrun debt


/ 34

Deleveraging shockDebt, consumption and investment

Two phases in the dynamics of debt:

Until T ∗ (T ∗∗), smooth deleveraging at rate γe/πt (γ/πt )After T ∗ (T ∗∗), debt picks up quickly: real estate is again valuable ascollateral ⇒ asset prices, credit and investment "virtuous circle"

Consumption follows a similar pattern to debt

Investment recovers somewhat earlier than consumption and debt(’creditless recovery’)


/ 34

Product market reform

We simulate a sudden, permanent fall in desired price markups (5%)


/ 34

Product market reform

0 20 40 6010

5

0

5GDP

quarters

%

0 20 40 6010

5

0

5employment

quarters%

0 20 40 6040

60

80


quarters

pp

0 20 40 6080

100

120


quarters

pp

0 20 40 6010

5

0

5real estate prices

quarters

%

0 20 40 6030

20

10

0

10total investment

quarters

%

0 20 40 606

4

2

0

2total consumption

quarters

%

0 20 40 606

4

2

0

2CPI inflation

quarters

annu

aliz

ed p

p

0 20 40 605

0

5real wage

quarters

%

0 20 40 601

0

1

2


quarters

annu

aliz

ed p

p

0 20 40 604

2

0

2terms of trade

quarters

%

0 20 40 6050

0

50

100net exports

quarters

%

baselinereform


/ 34

Product market reform: macro effects

Long run:

GDP goes up, employment remains stable (real wages and labourshare go up)

Short/medium run:

GDP and employment fall by less than in the baseline

Investment behaves significantly better, anticipating higher futuredemand.

Consumption falls slightly below the baseline

Additional terms of trade depreciation fuels gross exports, though netexports worsen due to stronger domestic demand


/ 34

Product market reform: positive effect on investment

Key question: How is the additional investment financed in the short term?- On the one hand,

Entrepreneurs current unit profits drop as markups fall

Deflationary effect of reform raises the real value of debt repayments

- On the other hand,

Higher asset prices → entrepreneurs’net worth is higher in the reformscenario

Entrepreneurs cut down their consumption significantly

Total demand goes up, pushing up profits


/ 34

Product market reform: deleveraging ends earlier

Reform brings forward the end of the deleveraging phase: T ∗ and T ∗∗

both go down.

Focus on T ∗ (entrepreneurs):

Higher initial net worth allows for more investment in the short termHigher investment today implies higher net worth and investmenttomorrow, and so onFaster recovery of net worth leads ceteris paribus to an earlier T ∗

Anticipation of earlier recovery of credit leads to higher asset pricestoday, higher net worth and investment, etc.


/ 34

Labor market reform

We simulate a sudden, permanent fall in desired wage markups (5%).

Model proxy for unions’bargaining power.


/ 34

Labor market reform

0 20 40 6010

5

0

5GDP

quarters

%

0 20 40 6010

5

0

5employment

quarters%

0 20 40 6040

60

80


quarters

pp

0 20 40 6080

100

120


quarters

pp

0 20 40 6010

5

0

5real estate prices

quarters

%

0 20 40 6030

20

10

0

10total investment

quarters

%

0 20 40 606

4

2

0

2total consumption

quarters

%

0 20 40 602

1

0

1CPI inflation

quarters

annu

aliz

ed p

p

0 20 40 606

4

2

0real wage

quarters

%

0 20 40 601

0

1


quarters

annu

aliz

ed p

p

0 20 40 604

2

0

2terms of trade

quarters

%

0 20 40 6050

0

50

100net exports

quarters

%

baselinereform


/ 34

Labor market reform (cont’d)

Long-run gains in GDP and employment

Short/medium-run effects:

No effect on GDP on impact, then gradual improvementSimilar effect on employment (main variable targeted by such a reform)

Positive short/medium-run effects smaller than those of productmarket reform:

Investment does not respond positively: entrepreneurs meet higherdemand by hiring more (cheaper) laborEntrepreneur consumption slightly increases⇒ forces that brought T ∗’s forward with product market reform arenot active now


/ 34

Broader labor market reform

Reduction in desired wage markups must overcome a double layer ofnominal rigidities (wages and prices) before affecting pricecompetitiveness

Typically, labor market reforms affect not only markups, but alsospeed of nominal wage adjustment

Spain’s 2012 reform a clear example!

Consider a broader labor market reform that also reduces nominalwage rigidity

Reduce Calvo parameter from 3/4 to 2/3 (average wage duration from4 to 3 qrts)


/ 34

Broader labor market reform

0 20 40 6010

5

0

5GDP

quarters

%

0 20 40 6010

5

0

5employment

quarters%

0 20 40 6040

60

80


quarters

pp

0 20 40 6080

100

120


quarters

pp

0 20 40 6010

5

0

5real estate prices

quarters

%

0 20 40 6030

20

10

0total investment

quarters

%

0 20 40 606

4

2

0

2total consumption

quarters

%

0 20 40 603

2

1

0

1CPI inflation

quarters

annu

aliz

ed p

p

0 20 40 606

4

2

0real wage

quarters

%

0 20 40 601

0

1

2


quarters

annu

aliz

ed p

p

0 20 40 604

2

0

2terms of trade

quarters

%

0 20 40 6050

0

50

100net exports

quarters

%

baselinereform


/ 34

Further analysis

Two important channels for understanding the positive short-runeffects of reforms:

The role of the external sectorThe role of long-term debt


/ 34

The role of the external sector

Responsiveness of net exports to reform-driven depreciation in terms oftrade is key

0 5 10 15 20 25 30 35 400.5

0

0.5

1

1.5

2

2.5

3

3.5

4Product market reform, export elasticity

quarters

%

εF = 1 (baseline)εF = 0.5εF = 1.5

0 5 10 15 20 25 30 35 400.4

0.2

0

0.2

0.4

0.6

0.8

1

1.2Labor market reform, export elasticity

quarters

%

εF = 1 (baseline)εF = 0.5εF = 1.5

0 5 10 15 20 25 30 35 400.4

0.2

0

0.2

0.4

0.6

0.8

1

1.2Labor market reform, import elasticity

quarters

%εH = 1 (baseline)εH = 0.5εH = 1.5

0 5 10 15 20 25 30 35 400.5

0

0.5

1

1.5

2

2.5

3

3.5

4Product market reform, import elasticity

quarters

%

εH = 1 (baseline)εH = 0.5εH = 1.5

Differential effect of reform on GDP


/ 34

The role of long-run debt

Entrepreneurial net debt flows (gross of interest payments) duringdeleveraging phase (bet = γebet−1/πt , t ≤ T ∗):

Rt−1πt

bet−1 − bet =Rt−1 − γe

πtbet−1

=

net interest rate︷︸︸︷(Rt−1 − 1) +

amortization rate︷︸︸︷(1− γe )

πtbet−1.

Long-run debt ⇒ amortization rate 1− γe is small ⇒ debt deflationeffect (↓ πt) from reform is small!


/ 34

Concluding remarks

Structural reforms may boost GDP and employment already in theshort run...

... even without monetary accommodation

Especially true for product market reform (brings forward end ofdeleveraging/recession)

Also true for a broad labor market reform that includes higher wageflexibility

Long-run debt buffers short-term costs of reforms


/ 34

structural reforms in a debt overhangstructural reforms in a debt overhang javier andrØs1, Óscar...

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