IV. Analytical Note 4: Macroeconomic Deleverage Scenarios1
1. This paper uses the IMF’s Global Integrated Monetary and Fiscal (GIMF) model to study the possible effects of rapid bank deleveraging on the various regions of the global economy. Against this background, the paper then examines the implications for Finland, and whether domestic fiscal policy can mitigate the spillovers to domestic growth from such deleveraging.
2. The GIMF model—described in detail in Kumhof et al. (2010)—as used in this paper is a six-region dynamic structural general equilibrium model of the global economy, with optimizing behavior by households and firms, and full intertemporal stock-flow accounting. Frictions in the form of sticky prices and wages, real adjustment costs, liquidity constrained households, and finite planning horizons of households, give the model certain key properties—notably, an important role for monetary and fiscal policy in economic stabilization. The regions that we calibrate the model to are Finland, Rest of euro area, USA, Japan, Emerging Asia, and Rest of World. Model calibration includes inter alia matching the trade flows, great ratios, and fiscal shares.
3. The results indicate that deleveraging has a substantial adverse impact on global growth, with the euro area hardest hit. The strong initial fiscal position of Finland could provide some cover from the worst spillover effects of deleveraging, sparing it from the need to further tighten fiscal policy. However, in an extreme stress scenario where Finland is not spared, the resulting fiscal tightening leads to an improvement in its fiscal and external balances, notwithstanding a marked contraction in GDP.
B. The Model
4. The assumption of finite horizons separates GIMF from standard monetary DSGE models and allows it to have well-defined steady states where countries can be long-run debtors and creditors. This allows users to study the transition from one steady state to another where fiscal policy and private saving behavior play a pivotal role in both the dynamic adjustment to and characteristics of the new steady state.
5. There are two types of households, both of which consume goods and supply labor. First, there are overlapping-generation households that optimize their borrowing and savings decisions over a twenty year planning horizon. Second, there are liquidity-constrained households, who do not save and have no access to credit. Both types of households pay direct taxes on labor income, indirect taxes on consumption spending, and a lump-sum tax.
6. Firms, which produce tradable and nontradable goods using capital and labor, are managed in accordance with the preferences of their owners, finitely-lived households. Therefore, firms also have finite planning horizons. The main substantive implication of this assumption is the presence of a substantial equity premium driven by impatience. Firms are subject to nominal rigidities in price setting as well as real adjustment costs in labor hiring and investment. They pay capital income taxes to governments and wages and dividends to households.
7. There is a limited menu of financial assets. Government debt consists of nominally non-contingent one-period bonds denominated in domestic currency, and is only held domestically. Banks offer households one-period fixed-term deposits, their source of funds for loans to firms. These financial assets, as well as ownership of firms, are not tradable across borders. Optimizing households may, however, issue or purchase (and the US government may issue) tradable U.S.-dollar denominated nominally non-contingent one-period bonds. Uncovered interest parity does not hold, due to the presence of country risk premiums. The premiums create deviations, both in the short run and the long run, between interest rates in different regions, even after adjustment for expected exchange rate changes. Equity is not traded in domestic financial markets; instead, households receive lump-sum dividend payments.
8. There is a financial sector as described in Bernanke et al. (1999), which incorporates a procyclical financial accelerator, with the cost of external finance facing firms rising with their indebtedness.
9. As GIMF is multi-region, encompassing the global economy, all bilateral trade flows are explicitly modeled, as are the relative prices for each region, including exchange rates. These flows include the export and import of intermediate and final goods. They are calibrated in the steady state to match flows observed in the recent data. International linkages are driven by the global saving and investment decision, a by-product of consumers’ finite horizons. This leads to uniquely defined current account balances and net foreign asset positions for each region. Since asset markets are incomplete, net foreign asset positions are represented by nominally non-contingent one-period bonds denominated in U.S. dollars. Along with uncovered interest parity, and long-term movements in the world real interest rate, the magnitudes of the international trade linkages are the main determinant of spillover effects from shocks in one region onto other regions in the world.
10. Fiscal policy is conducted using a variety of fiscal instruments related to spending and taxation. Government spending may take the form of consumption or investment expenditure or lump-sum transfers, to either all households, or targeted towards liquidity-constrained households. Revenue accrues from the taxes on labor income and capital, consumption taxes, and the lump-sum tax, mentioned above. Government investment spending augments public infrastructure, which depreciates at a constant rate over time. When conducting monetary policy, the central bank uses an inflation-forecast-based interest rate rule. The central bank varies the gap between the actual policy rate and the long-run equilibrium rate to achieve a stable target rate of inflation over time.
C. Deleveraging Scenarios
11. The deleveraging scenarios estimate the global macroeconomic impact of a shock to credit growth resulting from the sovereign debt distress in the euro area. More bank capital is needed to deal with a partial meltdown of the euro area sovereign bond markets. In the last fall, the European Banking Authority estimated that there is a need to build up an EU capital buffer of 114.5 billion euros to meet a 9% Core Tire I threshold (see ECB, 2011). This build up of the capital buffer is achieved either fully or partially via loan book retrenchment. Based on this figure, ECB (2011) estimated that GDP growth would decrease by 1.6– 3% in the short-run. The ECB estimates are used to calibrate the effect on economic activity in the GIMF model. In specific, the higher costs of borrowing, for both firms and households, are used to replicate the GDP impacts individually for each region in GIMF. The increased borrowing costs are then imposed in all regions to capture the full global impact. Moreover, it is assumed that the fiscal distress also requires further fiscal austerity in the euro area.
12. Two scenarios are considered, based on the assumed severity of spillovers to Finland. In the first “stress” scenario, Finland dodges the bullet and is able to partially avoid increases in both sovereign and corporate spreads and abstains from further fiscal austerity. In the second “extreme stress” scenario, Finnish spreads widen more substantially, forcing additional fiscal retrenchment.
13. In the stress scenario we assume that the increased fiscal distress increases sovereign spreads by an additional 100 basis points for two years after which they return to baseline gradually. Furthermore, we assume a temporary increase in the country risk premium by 25bps. In addition, the increased concerns about the fiscal sustainability enforce additional fiscal tightening, defined as one percentage point of GDP improvement in the fiscal balance in the euro area for three years followed by a gradual return to the baseline. For Finland, however, we assume that the additional need for further fiscal austerity is only 20 percent of that in the euro area, given its strong initial fiscal position and low public debt.
14. The decline in credit is calibrated to increase corporate spreads by 500 basis points. Although this is a sudden increase in the borrowing costs which fades away as time passes by it hits the private sector investments hard. For Finland, however, we assume that the pressure from the credit spreads is only 20 percent of that in the euro area.
15. Financial market spillovers are assumed to be two-thirds of the magnitude observed in the aftermath of Lehman Brothers Holdings Inc. bankruptcy. This is so because the historical evidence suggests that the euro area shocks may have smaller effect than those emanating from the United States. The increase in euro area corporate spreads is transmitted to the U.S. with correlation coefficient 0.4, 0.2 to Japan, 0.45 to emerging Asia and 0.5 to remaining countries.
16. In the second “extreme stress” scenario we assume that Finland is unable avoid the demands for further austerity and that both sovereign and corporate spreads increase in unison with the euro area. This means that Finland acts as any other euro area country and no credit is given to a relatively good fiscal stance.
17. In both scenarios the shocks for each region are then imposed simultaneously in all regions to generate the global impact. Furthermore, it is assumed that in the first two years the policy interest rates are constrained from falling below the zero lower bound in the euro area (including Finland), the United States, and Japan. The paths for several key macro variables are presented in Figure 4.1.
Figure 4.1.Deleveraging Scenarios
D. Model Predictions
18. The macroeconomic impacts of these shocks to bank credit are significant. In the stress scenario GDP in the euro area falls by 4 percent at its trough and inflation falls by 1½ percentage points. In Finland, GDP falls by 2 percent at its trough while the inflation rate falls 1 percentage points. The next most affected region is the United Sates, were GDP declines by close to 1¾ percent and inflation falls one percentage point. The impact on Japan and Emerging Asia are only slightly smaller to the magnitude in the United States although the shock to bank capital in these countries is much smaller. This reflects that Japan and Emerging Asia are more open and the shock in the rest of the world has a larger impact through trade and the fact that the zero lower bound on interest rates is a binding constraint in Japan. In the Rest of the World, GDP falls by roughly 1½ percent. However, there will be a large divergence across the countries contained within this region. In those with strong banking and trade ties with the euro area, such as the United Kingdom, Norway, Sweden, Russia, and eastern European countries outside the euro area, the impact is likely to be between the impact in the euro Area and the United States. Other countries contained within this block, would likely have impacts similar to or smaller than those simulated for Asia.
19. In the extreme stress scenario GDP falls by 4 percent and inflation falls by 1½ percentage points both in the euro area and in Finland. Given the small share of Finland in the global economy, the only differences are with regard to the Finnish economy, as domestic Finnish policy has negligible impact externally. With stronger adverse spillovers and correspondingly tighter fiscal policy, Finland’s fiscal position and external balance are projected to improve, notwithstanding the more severe growth shock.
BernankeB. S.M.Gertler and S.Gilchrist1999 “The Financial Accelerator in a Quantitative Business Cycle Framework” in John B.Taylor and MichaelWoodfordeds.Handbook of Macroeconomics Volume 1cAmsterdam: Elsevier.
European Central Bank (ECB)2011Box 1 Quantifying Deleveraging Effect from Recapitalizing EU Banks ECB Risk Analysis ReportEuropean Central BankDecember.
Prepared by Mika Kortelainen.