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Journal of Monetary Economics

Journal of Monetary Economics 61 (2014) 143–147

0304-39http://d

DOI of on CorrE-m1 A

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Discussion

Comment on “Sovereign debt markets in turbulent times:Creditor discrimination and crowding-out effects” by Broner,Erce, Martin and Ventura

Mark L.J. Wright a,b,n

a Federal Reserve Bank of Chicago, United Statesb National Bureau of Economic Research, United States

a r t i c l e i n f o

Article history:Received 9 December 2013Available online 25 December 2013

1. Overview

The European sovereign debt crisis emerged with startling speed. As late as April of 2008, the spread between yields on10 year Greek sovereign bonds and yields on similar German sovereign bonds averaged roughly 50 basis points. A year later,in March of 2009, these spreads had increased almost six-fold and averaged 285 basis points, while by September 2010 theyfluctuated around 900 basis points. As shown in Fig. 1, spreads on Portuguese, Irish, Italian and Spanish sovereign bondsmoved similarly although less dramatically.

The crisis has also been associated with significant contractions in the most severely affected economies. Although someof these declines began prior to the rise in spreads, in the years after 2008 these declines have continued in many countriesso that by 2013 output remained depressed relative to its 2007 level by 6% in Spain, roughly 7% in Portugal and Ireland, 8.6%in Italy and a whopping 23% in Greece.1

What factors led to the sudden rise in spreads and the onset of the European sovereign debt crisis? Did the crisiscontribute to the contraction in economic activity? And if so, through what mechanism did the crisis lower output? In thispaper, Broner et al. (this issue) (hereinafter BEMV) propose a framework that is helpful in thinking about the answers tothese questions. The framework has three essential elements: (E1) the governments of sovereign countries are assumed tofavor domestic creditors in the event of a default; (E2) building on the authors earlier work (e.g. Broner et al., 2010),secondary markets in sovereign debt are assumed to allow for the frictionless transfer of debt from foreign to domesticcreditors; and (E3) domestic agents are limited in their ability to access international financial markets.

Using a series of simple and elegant models, BEMV illustrate how the combination of these elements can generatebehavior similar to that observed in the crisis. Most notably, first, in Section 2.2, they show how an exogenous increase inspreads, driven by an increase in default risk, can generate declines in output. The logic works as follows. As default riskrises, E1 generates higher returns to domestic purchases of sovereign debt which are facilitated through E2. As a result offinancial frictions E3, which limits the ability of domestic residents to borrow abroad to finance domestic investment, these

32/$ - see front matter Published by Elsevier B.V.x.doi.org/10.1016/j.jmoneco.2013.12.002

riginal article: http://dx.doi.org/10.1016/j.jmoneco.2013.11.009espondence address: Federal Reserve Bank of Chicago, 230 S La Salle Street, Chicago IL 60604-1413, United States.ail address: Mark.Wright@chi.frb.orgll of these data come from Eurostat0s Annual National Accounts database which includes a preliminary estimate for 2013.

0%

10%

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30%

0%

10%

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30%

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Euro introduced1st January 1999

Germany

Greece

Portugal

Ireland

Italy

Spain

Fig. 1. European 10 year government bond yields. Source: Eurostat, EMU Convergence Criterion Database. Notes: Data are derived from secondary marketdata on the prices of government bonds issued in local currency with a residual maturity of around 10 years.

M.L.J. Wright / Journal of Monetary Economics 61 (2014) 143–147144

purchases of sovereign debt crowd out a similar amount of domestic investment reducing the capital stock and depressingoutput.

Second, in Section 4 they show how the decision to default can be made endogenous and how, if the cost of default isincreasing in the size of the economy, this can lead to multiple equilibria and self-fulfilling debt crises. Intuitively, if marketsthink the sovereign will default, spreads will rise, domestic residents will buy sovereign debt and in the process crowd outdomestic investment and shrink the size of the economy. This causes the cost of default to decline which may, if parametervalues are right, justify the initial increase in default risk. The authors also present a range of empirical evidence in supportof their mechanism. In particular they show that the crisis has been associated with a redistribution of debt holdings fromforeign to domestic residents, a decline in the amount of domestic credit being allocated to the private sector, and anincrease in private sector borrowing costs.

The combination of a novel theory with a range of empirical evidence makes this paper an especially valuablecontribution to the literature. Set against these contributions, the rest of these comments have three simple objectives. First,they attempt to place the contributions of the paper in the context of the existing literature on sovereign debt. Second, theybring some additional empirical evidence to bear on the mechanism described by the authors and show that, at least alongsome dimensions, the theory of BEMV is inconsistent with the data on Europe crisis countries. Third, they attempt to lay outsome potentially fruitful directions for future research on this important topic.

2. Output and productivity declines during sovereign debt crises

There has been a substantial amount of work directed at documenting and explaining the output declines that often (butnot always; see Tomz and Wright, 2007; Benjamin and Wright, 2008 who have found that sovereign defaults are in somecases associated with “good times” in which output is rising and/or is above its Hodrick–Prescott trend) occur duringinternational financial crises, which includes but is not limited to sovereign debt crises. Much of this literature has viewedthese output declines as a puzzle. From a theoretical perspective, the declines are puzzling for at least two reasons. First, inresponse to a crisis in which wealth declines, standard theory suggests households should increase their labor supplygenerating, everything else equal, an output boom (e.g. Chari et al., 2005). Second, although it is not uncommon forinvestment to drop dramatically during a crisis, the observed declines do not seem quantitatively significant enough toexplain the observed declines in output. To understand this, consider the following back-of-an-envelope calculation. Even ifinvestment falls by as much as 10% of Gross Domestic Product (GDP), given that the stock of capital is on the order of threetimes GDP, this constitutes only a 3% decline in the capital stock. Moreover, given an output elasticity of capital on the orderof one-third, this should only translate into only a 1% reduction in GDP.

Table 1Decomposition of growth in Europe, 2007–2012.

Germany Greece Ireland Italy Portugal Spain

GDP 3.57 �22.07 �6.66 �6.90 �5.61 �4.28Contribution of :(i) Capital services 2.82 5.79 8.05 1.47 4.49 4.95

of which:(a) Information and communications technology 1.73 3.52 2.89 0.56 3.69 1.23(b) Other capital 1.09 2.27 5.16 0.91 0.80 3.72

(ii) Labor services 2.19 �7.38 �10.90 �4.01 �3.52 �6.36(iii) Total factor productivity �1.44 �20.48 �3.81 �4.36 �6.58 �2.87

Source: The Conference Board Total Economy Database ™ , January 2013, http://www.conference-board.org/data/economydatabase/Notes: Annual data. Growth rates are log differences. The contributions of TFP and both types of capital are taken from the database, while the contributionof labor services is calculated as a residual.

M.L.J. Wright / Journal of Monetary Economics 61 (2014) 143–147 145

Declines in output during financial crises are also puzzling from an empirical accounting perspective in the sense thatthey are typically not explained by declines in measured factor usage. That is, the declines in output are largely “explained”as resulting from declines in total factor productivity. This puzzling behavior is very much in evidence during the Europeansovereign debt crisis. Table 1 presents a decomposition of growth in six major European countries during the crisis ascalculated by The Conference Board in their Total Economy Database which provides a consistent and careful calculation offactor input usage and total factor productivity growth across a large number of countries. These data are available until2012, which explains why the output declines in Table 1 differ slightly from those cited in the introduction that usedpreliminary data for 2013. Nonetheless, the picture is similar with significant declines across the five main crisis countriesheadlined by the dramatic 22% decline in output in Greece between 2007 and 2012.

As shown in Table 1, at most a modest amount of the decline in output can be explained by declines in factoremployment. In the case of Greece more than 90% of the decline in output is attributed to total factor productivity, while itlikewise accounts for 120% of the decline in Portuguese output and roughly 60% or more in Ireland, Italy and Spain. Alsostriking, in light of the central role played by capital in the BEMV model, is that fact that the usage of capital services hasbeen found to be a positive contributor to growth in all of the 5 crisis countries. Similar findings come from other databasesof factor usage and productivity growth. For example, the OECD0s Productivity Statistics (http://www.oecd.org/std/productivity-stats/), which are currently available up to 2011, record positive growth in the employment of capital servicesin Ireland, Italy, Portugal and Spain between 2007 and 2011 (data for Greece is unavailable).

This suggests that what is needed is a theory of why labor and, most importantly, productivity declines during financialcrises. Indeed, a significant literature has arisen in response to this need. Possible explanations that have been consideredinclude the reallocation of resources from high productivity to low productivity sectors (Benjamin and Meza, 2009,Sandleris and Wright, in press), deteriorations in the quality of the allocation of resources across firms (Sandleris andWright, in press), and decreases in the quality and variety of imported intermediate inputs (Gopinath and Neiman, 2011)amongst others. It is also possible that the declines reflect the mismeasurement of output: although Kehoe and Ruhl (2008)show that changes in the terms of trade, which frequently occur during financial crises, should not manifest as changes intotal factor productivity if GDP is correctly measured using double deflation, Sandleris and Wright (in press) note that manycountries measure significant parts of their national accounts using variants of single deflation and the gross output method.

In summary, the data seem to be at variance with BEMV0s theory of output declines during sovereign debt crises in so faras declines in capital services have not been observed. This need not be fatal to their theory, although it does require asignificant modification. As one possibility, the increases in financing costs of private firms that occur in BEMV0s model couldbe used to explain the observed declines in labor inputs if firms face working capital constraints as in Neumeyer and Perri(2005) (see also Mendoza and Yue, 2012 for a version in which intermediate input usage requires working capital).As another, the increases in private borrowing costs may explain declines in productivity if they cause reallocation ofresources to sectors and/or firms that have lower needs for external finance and if those sectors and/or firms have lowerproductivity.

3. The determinants of spreads and the causes of the crisis

Fig. 1 plots a version of what is fast becoming the most famous graph in all of international macroeconomics: yields on 10year sovereign bonds for a number of European economies since the early 1990s. As shown in Fig. 1, there are two strikingepisodes in the evolution of European sovereign bond yields. The second episode is the dramatic widening in spreadsobserved since 2007, which is the focus of BEMV. Equally as striking, however, is the first episode in which spreads weredramatically reduced in the lead-up to the adoption of the Euro on 1st January 1999. Between 1990 and 1999, the spreadbetween the yields on 10 year sovereign bonds in Italy, Spain and Portugal dropped from in excess of 6% to roughly 20 basispoints. In the case of Greece, the narrowing of yields was even more dramatic, with spreads dropping from roughly 17% inlate 1992 to under 2% in 1999 before declining to around 50 basis points early in 2001.

M.L.J. Wright / Journal of Monetary Economics 61 (2014) 143–147146

The canonical model of sovereign debt due to Eaton and Gersovitz (1981) is capable of explaining the dramatic wideningsand narrowings of spreads observed in the data. In calibrated versions of that model (e.g. Arellano, 2008; Aguiar andGopinath, 2006) there is typically a threshold region for debt levels and output in which spreads can move from zero to highlevels. However, these models almost invariably produce an immediate default in such situations and, although thisoccurred in Greece, this was not observed in Ireland, Italy, Portugal and Spain. As a consequence, it seems necessary toconsider alternative explanations.

A number of alternative theories have been, or might be, postulated (although relatively few formal models have beenwritten down) to explain these aspects of the observed behavior of European sovereign spreads. First, it might be the casethat spreads narrowed due to the removal of exchange rate risk with the adoption of the Euro. Taking this line of argumentseriously, the widening in spreads post 2007 would presumably be attributed to the prospect of countries abandoning theEuro, although this would involve concerns about credit risk as much as currency risk.

A second theory, that is often floated in the press and in policy circles, is that the behavior of spreads reflects changes inthe perception of fundamental credit risk. Many versions of this story can be told. In my version, the initial narrowingof spreads reflects some combination of three factors. First, it may reflect a belief by market participants that progresstowards the Maastricht targets reduced credit risk in individual countries. Second, it may reflect the view that a country thatdefaults on its debts while being a member of a currency union faces larger costs than a country with its own currency, thusreducing the incentive to default. Third, it may also reflect the belief that, the anti-bailout provision in Article 125 of theTreaty on the Functioning of the European Union notwithstanding, there existed an implicit guarantee under which thecountries of the Eurozone would act to prevent a default by any of its members. Similarly, the later widening in spreadsreflects the declining fiscal positions of the crisis countries, the revelation that Greek public finances were in a worseposition than initially reported, along with the growing realization that bailouts were unlikely to make creditors whole inthe event of a default.

A third theory is that the movements in spreads reflect movement between a pooling equilibrium in which all Eurozonecountries debts are priced identically, and a separating equilibrium in which these debts are priced differently. A version ofthis theory has been formalized by Catao et al. (2012) who consider a model in which a set of countries differs in terms ofthe volatility and persistence of their revenue streams in ways that are unobserved to investors. When revenues are high, allcountries maintain similar borrowing levels and face similar interest rates as they are pooled in the eyes of investors. Whenrevenues decline, however, low volatility countries adjust their spending while high volatility countries increase borrowingbreaking the pooling equilibrium and resulting in divergence of spreads.

A fourth theory, or class of theories, examines the possibility of multiple equilibria in which shifts in expectations can movethe economy between different equilibria. The potential for multiple equilibria in the canonical model of sovereign debt due toEaton and Gersovitz (1981) is well known and derives from familiar logic: if creditors think a country will default they will chargea higher interest rate which gives the country a greater incentive to default. Although this logic is present, calibrated versions ofthese models typically do not exhibit multiple equilibria and researchers have proposed other mechanisms through whichmultiple equilibria can emerge. Perhaps the best known is the theory of rollover crises of Cole and Kehoe (2000) in whichsovereign borrowers must contract new debts before repaying old debts. In this world, if creditors believe that a default is likely,they will not issue new debts making it impossible to roll over the old debts and forcing a default.

The model in Section 4 of BEMV can be viewed as a contribution to this fourth class of theories. In the BEMV version,multiple equilibria arise because if creditors believe a default is likely, this increases spreads, which leads domestic investorsto purchase sovereign debt thus crowding out domestic investment which reduces output and, by assumption, also reducesthe cost of default. Thus, the possibility for self-confirming debt crises results.

Can we discriminate between these candidate theories? BEMV seem inclined to dismiss the second theory in whichchanging perceptions of credit risk drive the behavior of spreads because it is not clear why perceptions changed thisquickly. Likewise, BEMV argue against the roll-over theory of self-fulfilling debt crises by pointing to the relatively long, andin some cases lengthening, maturity of many European sovereign0s debts during the crisis (see Fact 3 in Section 1).Nonetheless, with debt levels on the order of 70% or more of GDP in Europe, even if maturities are on the order of 7 years,this implies that on average a sovereign will need to roll-over an amount of debt equal to 10% of GDP, which plausiblyexposes even these countries to a roll-over crisis.

Moreover, BEMV present a range of evidence that is consistent with their mechanism that, for the most part, the othertheories of sovereign debt crises are silent upon. Most notably, BEMV show that as spreads rose, sovereign debt holdings did shifttowards domestic creditors (Fact 4 in Section 1), and that credit to the private sector of these economies decreased (Fact 5).

Could these other theories be modified to be made consistent with these data? As someone very wise once said “it takesa model to beat a model” and I will not offer an alternative model here. Rather, I will take the scoundrel0s approach ofconjecturing what such a model might look like. One mechanism seems especially promising. As was remarked upon duringthe crisis, when the possibility of declaring bankruptcy limits losses on investments, or when domestic financial institutionsare likely to suffer large losses when their government defaults independently of their own investments, suchintermediaries may have an incentive to take excessive risks and invest in their own governments debt. Thus, even inthe absence of the ability of a sovereign to discriminate in favor of domestic residents, domestic financial institutions mayhave an incentive to buy the debts of their own governments facilitating the repatriation of debts documented by BEMV andcreating similar crowding out effects. There is evidence that this mechanism has worked in other sovereign debt crises.Ippolito (2002) and Livshits and Schoors (2007) show that during the Russian debt crisis of 1998, since a default was likely

M.L.J. Wright / Journal of Monetary Economics 61 (2014) 143–147 147

to be accompanied by a devaluation of the ruble, those banks with the greatest exposures to Russian sovereign debt werealso the most exposed to devaluation risk through their use of currency forwards.

4. Conclusions

In summary, BEMV have presented us with a framework for understanding the causes of sovereign debt crises as well asthe mechanism through which they are associated with prolonged periods of depressed economic activity. The mechanismthey exposited also appears to be consistent with some facts regarding the allocation of sovereign bonds between foreignand domestic residents and the allocation of bank credit between the public and private sectors. However, there remainswork to do to show that the mechanism can be made qualitatively consistent with the changes in factor allocations andproductivity during the crisis documented above, and that it is quantitatively relevant.

These concerns about the results should not detract from the contributions of the paper. Rather, they should indicate thepresence of high returns to further research on this important topic.

References

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