Research

 

Are All Sovereign Defaults Strategic? (revised October, 2022)

 

The Greek default crisis does not fit stylized facts for strategic default. We extend the strategic default model to allow excusable and strategic default. We replace the assumption that default exit is random and costless with the assumption that exit can be chosen any time with payment of recovery value. Recovery is determined by ability to pay, consistent with IMF guidelines that a defaulting sovereign negotiate "in good faith," reducing debt to something "sustainable." Payment of recovery is excusable default, whereas non-payment is strategic. The extended model matches behavior leading to the Greek crisis and identifies it as excusable.

 

 

The Greek Crisis: Strategic vs Excusable Default (Journal of International Economics, September, 2022) co-authored with Jinwook Nam

 

The Greek debt crisis revealed that sovereign default is not limited to emerging and developing countries. Can we take the strategic default model, developed for emerging markets, and recalibrate it to explain the crisis in Greece? The Greek economy differs from an emerging market in having higher government debt relative to GDP, counter-cyclical government debt, and consumption smoother than income. Our recalibrated strategic default model matches the high debt/GDP, but it misses the other two features of advanced countries. And it fails to generate a crisis. We propose an alternative model, replacing the absence of commitment to repay with commitment. Default occurs due to inability to repay and is excusable. Our alternative model of excusable default allows us to match the behavior of debt and the spread as the crisis approaches, as well as key features of business cycles in advanced countries. It also generates a crisis with correct timing.

 

 

Sovereign Default in a Rich Country (revised July, 2019)

 

Rising debt following the Great Recession climaxed in the Greek debt crisis. Yet, this crisis did not evolve as a typical strategic default crisis. Debt/GDP reached levels much higher than could be supported by standard costs to default. Debt was countercyclical in the decade prior to the crisis. As the crisis approached, debt spiked, instead of falling. We argue that a rich-country sovereign faces different incentives for default, which alter debt dynamics. We modify the strategic default model to have a reputational equilibrium by introducing multiple contracts with spillovers in value. Default occurs only due to inability to repay and is excusable if the sovereign repays what she is able. We calibrate to the 2010 Greek crisis, and demonstrate that the rich-country default model allows much larger values for debt/GDP than strategic default and matches Greek debt dynamics prior to the crisis. We use the calibrated model to explain crisis severity, including magnitudes for endogenous risk premia, haircuts, and default duration.

 

Identifying Countries at Risk of Fiscal Crises: High-Debt Developed Countries (Canadian Journal of Economics, May, 2022) co-authored with Christos Shiamptanis

 

Crises in European countries in 2010 and beyond demonstrated that fiscal crises and sovereign default are not confined to emerging and developing countries. Advanced economies can sustain much larger debt-to-GDP ratios than emerging economies, but how much larger? Experience is heterogeneous both across countries and across time. What determines this heterogeneity? We show that a low growth-adjusted interest rate, a large maximum value for the primary surplus, and a strong surplus-responsiveness to debt can support higher debt-to-GDP ratios without fiscal crisis. We use our estimates to assess fiscal crisis risk for nine-high-debt developed countries following the financial crisis in 2008. Our results imply that Ireland and Portugal lost access to financial markets due to the rise in growth-adjusted interest rate, whereas Greece would have lost access regardless of the interest rate. Additionally, our results warn of potential future crises for Greece, Italy and Japan even if these countries remain in a low interest rate environment.

 

Asymmetries in Business Cycles and the Role of Oil Production (Macroeconomic Dynamics June, 2019) co-authored with Christian M. Hafner, Hans Manner, and Leopold Simar

We estimate asymmetries in innovations to Solow residuals for eleven OECD countries using Stochastic Frontier Analysis. Likelihood ratio statistics and variance ratios imply that all countries with net energy imports have significant negative asymmetries, while other countries do not. We construct a simple theoretical model in which the measured Solow residual combines effects from technology, factor utilization, and the terms of trade. For oil importers, the model implies an asymmetric response of measured TFP to oil price increases and decreases. When we condition Solow residuals separately on positive and negative oil price changes to allow asymmetric responses, evidence for remaining negative asymmetric innovations to the Solow residuals vanishes for all countries except Switzerland. Switzerland's relatively dominant financial sector suggests that their asymmetries could be due to a financial crisis, a hypothesis that we test and fail to reject.

Taylor-Rule Exit Policies for the Zero Lower Bound  (International Journal of Central Banking, December, 2018) co-authored with Siddhartha Chattopadhyay

The monetary authority loses the ability to implement the Taylor Rule at the zero lower bound. However, the promise to implement a Taylor Rule upon exit remains an effective policy instrument. We show that a Taylor Rule, with an optimally-chosen exit date and time varying inflation target, delivers fully optimal policy at the ZLB. Additionally, a Taylor Rule with only an optimally chosen exit date but a zero inflation target delivers almost all the welfare gains of optimal policy and is simpler to communicate.

The Implications of Productive Government Spending for Fiscal Policy  co-authored with Si Gao (Journal of Economic Dynamics and Control, June, 2015).

The standard assumption in macroeconomics that government spending is unproductive can have substantive implications for tax and spending policy. Productive government spending introduces a positive feedback between the tax rate, the productive capacity of the economy, and tax revenue. We allow marginal tax revenue to be optimally allocated between productive subsidies to human capital and utility-enhancing government consumption and calculate Laffer Curves for the US. Productive government spending yields higher revenue-maximizing tax rates, steeper slopes at low tax rates and higher peaks. The differences are particularly pronounced for the labor-tax Laffer curve. The use of tax revenue is an important determinant of the actual revenue that a tax rate increase generates.

A Graceful Return of the Drachma (European Economic Review, 2014)

A country participating in a monetary union is constrained by loss of control over seigniorage revenue. Once the government reaches its fiscal limit on ordinary taxation, it cannot turn to seigniorage for financing. We show that a monetary union country can increase its seigniorage revenue by reissuing its own currency even as it fully honors all outstanding debt obligations. We use a simple cash-in-advance model, with domestic currency demand motivated by the need to pay taxes, to show that this policy effectively redistributes seigniorage revenue away from other monetary union members toward the acting country. The magnitude of the seigniorage created by currency reissue is limited both by the relative size of the country and by money demand, and, therefore, by the tax base. If this seigniorage revenue is insufficient, some additional seigniorage is available by allowing the new currency to grow and depreciate over time and domestic real wages to fall.

Pushing the Limit? Fiscal Policy in the European Monetary Union  co-authored with Christos Shiamptanis (Journal of Economic Dynamics and Control 2013) (2006 data)

Governments are facing increasing scrutiny over debt and deficits following the worldwide recession and financial crisis which ended in 2009. Additionally, policy makers are confronted with the growing realization that they face fiscal limits on the size of debt and deficits relative to GDP. These fiscal limits invalidate Bohn's criterion for fiscal sustainability since it allows explosive debt relative to GDP, eventually violating any fiscal limit. The purpose of this paper is to derive restrictions on fiscal policy, necessary for the government to be expected to satisfy fiscal limits in the long-run. We show that the restrictions require that the primary surplus respond large enough to debt. Additionally, since fiscal limits rule out explosive behavior, they imply cointegration between debt and the primary surplus and between the primary surplus and output. We test these two equivalent empirical implications for a panel of ten EMU countries, and find that in the years preceding the financial crisis, fiscal policy was responsible, in the sense that governments did not expect to violate fiscal limits in the long run.

Fiscal Risk in a Monetary Union (slides) co-authored with Christos Shiamptanis (European Economic Review, August 2012)

We present a dynamic and quantitative model of a fiscal solvency crisis in a monetary union. Diverse fiscal policies, which are subject to fiscal limits and stochastic shocks, can threaten a monetary union. The fiscal limits arise due to distortionary taxation and political will. Stochastic shocks are random and could push a fiscally sound policy towards its limit. In equilibrium agents refuse to lend along a path which violates the fiscal limits, creating a fiscal solvency crisis. The dynamics leading to the crisis depend on the policy response to restore lending. We focus on two responses, default and policy switching. We simulate our model to quantify the probability of a fiscal solvency crisis in the European Monetary Union with fiscal variables at end of 2009 values. Our model predicts the Greek crisis which occurred and warns of an Italian one.

Private-Sector Risk and Financial Crises in Emerging Markets  (slides) (Economic Journal, June 2012) Vox Column

Investment necessary for growth is risky and often requires external financing. We present a model in which capital market imperfections separate countries into a safe credit club of industrial countries, with low interest rates and steady credit access, and a risky club of emerging markets, with high interest rates and volatile access. In an emerging market, a large negative productivity shock interacts with credit market imperfections to trigger a severe contraction in external lending. Domestic agents react with widespread default. We calibrate to South Korean parameters and argue that the 1998 financial crisis could have been the downside of risky investment financed in imperfect capital markets.

Exchange Rate Crises and Fiscal Solvency (slides) (Journal of Money, Credit, and Banking, September 2010)

This paper combines insights from generation-one currency crisis models and the Fiscal Theory of the Price Level (FTPL) to create a dynamic FTPL model of currency crises. The initial fixed-exchange-rate policy entails risks due to an upper bound on government debt and stochastic surplus shocks. Agents refuse to lend into a position for which the value of debt exceeds the present-value of expected future surpluses. Policy switching, usually combined with currency depreciation, restores fiscal solvency and lending. This model can explain a wide variety of crises, including those involving sovereign default. We illustrate by explaining the crisis in Argentina (2001).

The Fiscal Theory of the Price Level and Initial Government Debt (Review of Economic Dynamics, April 2007)

 It is widely believed that the Fiscal Theory of the Price Level (FTPL) does not work in an environment in which initial government debt is zero. This paper demonstrates that this view is incorrect when asset markets are incomplete and fiscal policy is stochastic. In particular, it is possible to define a stochastic non-Ricardian fiscal policy for which the set of equilibrium stochastic price processes under non-Ricardian fiscal policy is a subset of the set of equilibrium stochastic price processes under Ricardian fiscal policy.

Financial Liberalization and Banking Crises in Emerging Economies co-authored with John Jones (Journal of International Economics, May 2007).

Financial liberalization often leads to financial crises. This link has usually been attributed to poorly designed banking systems, an explanation that is largely static. In this paper we develop a dynamic explanation, by modeling the evolution of a newly-liberalized bank's opportunities and incentives to take on risk over time. The model reveals that even if a banking system is well-designed, in the sense of having good long-run properties, many countries will enjoy an initial period of rapid, low-risk growth and then enter a period with an elevated risk of banking crisis. This transition emerges because of the way in which the degree of foreign competition, the marginal product of capital, and the bank's own net worth simultaneously evolve.