Debt trouble

I was teaching "Financial Crises" in the CREI Macro Summer School last week (link here). As I was brushing up the syllabus, I realized just how much great work Mian and Sufi have done on the recent crisis. I already knew their paper in the QJE on the subprime crisis, where they show that areas with high latent demand for mortgages in 1997 (i.e. high denial rates) saw a big increase in lending, lower denial rates, higher LTVs, without any improvement in economic conditions. 

Now, they also have a paper (with Francesco Trebbi, in the AER) on the voting of Republicans and Democrats on the bailout packages for homeowners, and for the financial industry. Guess what? Your ideology matters.... but only up to a point. What also matters a lot are the economic interests of your constituents. So if you are a god-fearing Republican who believes in small government, Ronald Reagan, the right to bear arms, and not helping anyone in need... you may rethink the last bit if your constituents are looking at a lot of foreclosures. As Groucho Marx said - these are my principles, and if you don't like them, I have others.

Mian and Sufi also have a small new paper, published in the SF-Fed's Economic Letters, on which areas of the US are suffering the most from the current recession... and it's all about debt levels. The first thing that is stunning is the size of the debt binge in the last 10 years (figure above). The second killer chart in the paper looks at the differential performance in auto sales:

Counties with a lot of household debt saw a big decline in sales in the run-up to 2008 already, and have stayed depressed. The low-debt counties have roared back, as everyone should have done in a normal recovery. Slow recovery? Maybe there is something more to it than a bit of pump-priming via the government deficit, and QE1-3. Without inflation, it's hard to see what will help those suffering counties reduce their debt burdens.

All of this goes to show that the analogy of debt binges and alcohol-infused parties is quite apt - fun while the punch is on tab, less so the next morning. That was also the argument about the Great Depression, made by Barry Eichengreen and Kris Mitchener almost a decade ago (in a much underappreciated paper). The title? The Great Depression as a credit boom gone wrong.

When the facts change, I change my mind

About a year ago, I illustrated the standard debt-sustainability calculations with the case of Greece. If you plug in plausible numbers for growth, for interest rates, and for the debt stock, you get to a need for fiscal adjustment that is frightening. Indeed, it is so large – compared to, say, the fiscal tightening that undid the Weimar Republic – that one had to say “no way”. The necessary swing in the fiscal balance – from primary deficit to surplus – was around 10% of GDP.

Now, I am starting to think that this may not be mission impossible after all. The reason? It’s not what you think. For a while, much of the profession and, to a surprising degree, policy-makers seemed to have decided that the Alesina et al. view of fiscal adjustment was right – that you can cut yourself back to growth. The IMF has done some painstaking work last year, and this argument now looks pretty doubtful.

However, there is another story that can create a bit more hope. There is no question that countries that tax more are richer. Any scatterplot shows correlation is strong. Is it causal? Recent work by Besley and Persson says so. They look at the part of variation in tax capacity that can be explained by the history of military conflict after 1816. States with a history of lots of (expensive) wars still tax more; and that part of the variation is also strongly associated with being richer. Now, Dincecco and Prado (2010) have a new working paper in which they show that the number of battle deaths in the early modern period is also a good predictor of the taxman’s take today – and that this also explains how rich a country is. This strongly suggests that the link is causal – taxation is good for you.

Why? A lot of economics implies that high taxes should be bad. Disincentives for work and entrepreneurial activity are large; a bloated state is as likely as not to waste precious tax dollars. And yet, taxes also generate benefits. Besley and Persson show that capital markets work much better in countries where the government is more capable overall – enforcing laws, investing in education, building infrastructure, protecting property rights, ensuring that debts are collected. All of this costs money. Also, high tax revenue mostly means that everyone pays. The more uneven the tax burden, the lower the overall yield is likely to be. That would also imply that a high tax take is often associated with FEWER distortions.

It’s these kind of distortions in the PIIGS experiencing problems today that seem to suggest that maybe, there is a silver lining to the issue of excessive debts. In countries like Greece, Spain, and Portugal, the self-employed effectively escape taxation on a staggering scale. Many transactions take place with black money. Buying a house is often akin to a scene from a Hollywood gangster film – the buyer first goes to his or her bank, and exits with a suitcase full of cash. The cash is then exchanged at the notary’s office, before being paid in again by the seller. None of it is declared to the authorities. This is not some occasional, half-criminal type of transaction – this is the norm for house buyers today, in a Southern European EU country I know well. Taxation is hence not just too low relative to debt; it is also highly uneven, and hence, distortionary. For example, you end up with an awful lot of people working in property who should be working elsewhere.

As Spain, Greece, and Portugal, desperate to plug their fiscal holes, are scrambling to find fresh funds, they will have to go after the areas of the economy they have largely far left alone – such as construction, property transactions, and the self-employed. Many of the citizens that should, by rights, have been working in large companies in the taxed part of the economy are today working in the self-employed sector; only tax fraud makes this worthwhile, since it compensates for the low productivity of their labor. As that gap narrows, overall output will increase, and the tax take will rise. In the short term, austerity may spell hard times for the Club Med and Ireland. And yet, tax reform done right may very well pay rich rewards, not just in terms of revenue, but also in terms of economic efficiency. Maybe, Greece can pull it off after all.

Just how great is the euro for Germany?

I am at a conference in Berlin on sovereign debt. Last night, at one of the many pleasant restaurants serving remarkably good food at reasonable prices, one of our German colleagues held forth with a view I read a lot in the newspapers - that Germany should just bear the cost of endless bailouts since its industry was "benefitting so much" from the euro. Wage and price inflation elsewhere in the Eurozone made countries uncompetitive; Germany's wage restraint paid off, at the expense of the free-spending peripheral countries. The NYT has a story on changes in export shares of European countries in the last 10 years. The allegedly unfair advantage of the euro for German exporters should matter much less with the ROW -- the exchange rate versus the dollar, the pound, the yen can still adjust. What does the chart show? Germany's export share (relative to the rest of the continent) is up -- but it grew no faster within the Eurozone than for exports to the rest of the world. This doesn't prove that exports to the Eurozone wouldn't be lower if we had the DM, and it had appreciated a lot; but it takes the wind out of the sail of those commentators who argue that swapping shiny cars for junk bonds is such a great deal for the Germans that they should happily carry on doing it forever...