Debt Matters Research Articles

Fiscal Foundations of Inflation: Imperfect Knowledge

This paper proposes a theory of the fiscal foundations of inflation based on imperfect knowledge and learning. Because imperfect knowledge breaks Ricardian equivalence the scale and composition of the public debt matter for inflation. High moderate-duration debt generates wealth effects on consumption demand that impairs the intertemporal substitution channel of monetary policy: aggressive monetary policy is required to anchor inflation expectations. Counterfactual experiments, in an estimated medium-scale DSGE model, reveal the US economy would have been substantially more volatile over the Great Inflation and Great Moderation periods, had average debt been consistent with levels currently observed in Italy or Japan.

The Cost of Empowerment: Multiple Sources of Women’s Debt in Rural India

Poor women borrow from multiple sources. This study examines whether the source of debt matters for women’s role in household financial decisions. Drawing on a household survey from rural Tamil Nadu, we categorise women’s loans along the lines of accessibility and formality into ‘planned loans’ and ‘instant loans’. We find that ‘instant loans’ support women’s bargaining power in various types of household financial decisions, whereas ‘planned loans’ have no impact. This surprising result is better understood when the nature of ‘instant loans’ is examined – these are frequently usurious, involve coercive enforcement methods and are considered socially debasing. Hence women who use them perform a convenient role for their households and in return gain some negotiating power.

Does Gross or Net Debt Matter More for Emerging Market Spreads?

Does gross or net debt matter for long-term sovereign spreads in emerging markets? The topic is important for undestanding the borrowing cost implications of public assetliability management decisions (e.g. using assets to lower debt). We investigate this question using data on emerging market economies (EMEs) over the period 1998–2014. We find that both gross debt and assets have a significant impact on long-term sovereign bond spreads in emerging markets, with effects roughly offsetting each other (coefficients of opposite sign and similar magnitude). Hence, net debt seems more appropriate than gross debt when evaluating the impact of indebtedness on spreads. The empirical results suggest that an increase in net debt by 10 percentage points of GDP implies an increase in the spread by 100–120 basis points, and the effect is larger during periods of domestic distress. The key results from this empirical study are quite robust to alternative specifications and subgroups of EMEs.

Does Gross or Net Debt Matter More for Emerging Market Spreads?

Does gross or net debt matter for long-term sovereign spreads in emerging markets? The topic is important for undestanding the borrowing cost implications of public assetliability management decisions (e.g. using assets to lower debt). We investigate this question using data on emerging market economies (EMEs) over the period 1998–2014. We find that both gross debt and assets have a significant impact on long-term sovereign bond spreads in emerging markets, with effects roughly offsetting each other (coefficients of opposite sign and similar magnitude). Hence, net debt seems more appropriate than gross debt when evaluating the impact of indebtedness on spreads. The empirical results suggest that an increase in net debt by 10 percentage points of GDP implies an increase in the spread by 100–120 basis points, and the effect is larger during periods of domestic distress. The key results from this empirical study are quite robust to alternative specifications and subgroups of EMEs.

Dealing with a liquidity trap when government debt matters: Optimal time-consistent monetary and fiscal policy

How does the need to preserve government debt sustainability affect the optimal monetary and fiscal policy response to a liquidity trap? To provide an answer, we employ a small stochastic New Keynesian model with a zero bound on nominal interest rates and characterize optimal time-consistent stabilization policies. We focus on two policy tools, the short-term nominal interest rate and debt-financed government spending. The optimal policy response to a liquidity trap critically depends on the prevailing debt burden. While the optimal amount of government spending is decreasing in the level of outstanding government debt, future monetary policy is becoming more accommodative, triggering a change in private sector expectations that helps to dampen the fall in output and inflation at the outset of the liquidity trap.

Business and Economics Cycle, Financial Market Fluctuation, and Bank Profitability: Empirical Evidence from Indonesia

This study examines how economic cycles, business cycles, and financial market fluctuations affect bank profitability. The topic is relevant and important in the context of macro prudential policy and systemic risk in the banking sector in Indonesia. Evaluating how economics cycle, business cycle and financial market fluctuation influence the profitability of bank is important as such indicators could be used as early warning indicators in anticipating the banking instability that could lead to a more severe financial crisis.The sample of this study comprises of banks operating in Indonesia, which includes seven groups of banks: (1) commercial banks; (2) state-owned banks, (3) foreign exchange commercial banks; (4) non-foreign exchange commercial banks; (5) regional development banks; (6) joint venture banks; and (7) foreign banks. The data utilized in this study is panel data covering 13 consecutive years observation period (2000-2012), with a total of 91 firm-year observations.The factors examined in this study are based on the model of macro prudential indicators proposed by IMF (2001). The model states that there are three main groups of macroprudential indicators: (1) macro economics indicators; (2) aggregated micro prudential indicators; and (3) market-based indicators. The dependent variables in this study can be classified into two groups: (1) the components of profitability (net-interest income; non-interest income; operating costs; and profit before tax), and (2) the level of profitability (ROE and ROA). The study utilized the Generalized Method of Moment (GMM) regression which economically considered more superior in terms of efficiency and consistency than the traditional OLS regression models.The findings reveal that bank profitability is positively associated with the economic cycle factors such as GDP, but negatively affected by the exchange rate of USD/IDR. Among business cycle indicators, the result indicates that the net interest margin (NIM) has a positive and significant effect on bank profitability, while asset quality indicators, efficiency (BOPO) and credit risk (NPL) showed a negative effect on bank profitability. The findings on financial market fluctuations factors indicate that the stock market capitalization, capital market volatility index, as well as the proportion of foreign debt relative to GDP showed a negative effect on the profitability of banks.The implication of this paper is that policies aimed at controlling those factors found significantly induced bank profitability should be given priority in fostering financial intermediation. Since the indicators of macroeconomic cycles (GDP and exchange rate of USD/IDR), the bank business cycle indicators (asset quality, NPL, BOPO, and NIM), and fluctuations in the financial markets (stock market capitalization, capital market index volatility, as well as the proportion of foreign debt) matter for bank profits, the government and Central Bank should put more attention on the various factors as indicators that can be used as the early warning system to anticipate the occurrence of banking instability and to prevent a systemic financial crisis.

Fiscal Foundations of Inflation: Imperfect Knowledge

This paper proposes a theory of the fiscal foundations of inflation based on imperfect knowledge and learning. Because imperfect knowledge breaks Ricardian equivalence, the scale and composition of the public debt matter for inflation. High and moderate duration debt generates wealth effects on consumption demand that impairs the intertemporal substitution channel of monetary policy: aggressive monetary policy is required to anchor inflation expectations. Counterfactual experiments conducted in an estimated model reveal that the US economy would have been substantially more volatile over the Great Inflation and Great Moderation periods if US debt levels had been those observed in Italy or Japan. (JEL D84, E31, E32, E52, E62, H63)

The Debate on Expansionary Fiscal Consolidation: How Robust is the Evidence?

AbstractThis paper critically examines the key empirical evidence used to support the fiscal consolidation argument, complemented by a brief assessment of the limitations of the analytical foundation of the growth promoting benefits of the fiscal consolidation thesis. It also reviews the evidence on the debt-growth relationship at some length. It finds that the negative relationship between debt and GDP growth is influenced by outliers or exceptionally high debt-GDP ratios. It also points out that the composition of public debt matters. Additionally, the debt-GDP relationship appears to be non-linear—positive first and turning to negative, but there is considerable variation in the estimated turning or ‘tipping’ point, which is not helpful as a policy guide. Historical evidence does not lend support to the concerns that the current situation is likely to cause rapid upward spiraling of public indebtedness. Finally, the argument that fiscal consolidation is possible without adversely affecting growth is not based on robust empirical evidence. This conclusion is reinforced by a succinct overview of some country-specific experiences (Denmark, Ireland and United States).

Guest Editor’s Introduction to the Thematic Issue on Family Finance

Three papers in this volume were selected after rigorous peer reviews from papers presented at research forums sponsored by the Center for Financial Security at the University of Wisconsin-Madison. They each reflect the important themes of the Center’s research. The Center is an interdisciplinary research center that does applied research on issues of importance to the financial security of individuals and families. These papers, completed during the period that the Center was one of three national centers comprising the Social Security Administration’s Financial Literacy Research Consortium, represent key issues on which the Center focuses its work: vulnerable populations, measurement of financial literacy, and the relationship between financial literacy and financial behavior. Financial literacy implies the understanding of financial concepts relevant to one’s financial circumstances and whose application in decision making would improve financial decisions to the betterment of current and/or future financial well-being. This implies that financial education is not a ‘‘one size fits all,’’ but must be shaped to the context within which families and individuals make financial decisions, both to the current context of their lives and to their likely or preferred financial life trajectories. Improving financial literacy through education implies an understanding of what should be taught, to whom, and when. These papers highlight the complexity of financial literacy education which must take account of individual’s family circumstances and initial financial beliefs and behaviors. This introduction ties these papers together by highlighting their connection to the Center’s major research themes. The three papers all deal with different but very much related aspects of financial debt. Financing current consumption through debt can be either a boon or threat to financial security. Mortgages enable the consumption of housing services in the short run and the accumulation of an asset as the mortgage is paid off. Unsecured consumer debt allows for current consumption, which may include capital building purchases (e.g., education of self or children) but its accumulation and payments are not directly tied to the growth in family assets. Both types of debt may lead to improved family financial security or lead to financial distress. Dew’s paper argues that debt matters not just for financial well-being but to family stability. Financial literacy education may be good family policy. Even if it is widely recognized that family finances matter a lot to marital satisfaction, it remains unclear what particular components of family finances matter—what types of assets and debt threaten family stability and how the acquisition process and whose decisions increase that threat. His paper shows that debt matters differently to husbands’ and wives’ marital satisfaction implying that education must go beyond the simple lessons of ‘‘thrift’’ and ‘‘savings’’ but must be aware of how couples make and manage financial decisions. The paper by Levinger, Benton and Meier hypothesizes that the knowledge of one’s creditworthiness matters to the wise acquisition of debt. It is far too simple to caution families against the accumulation of debt since debt can adjust for the disparity between income and consumption needs at any point in time, raising families’ economic wellbeing over time. But debt must be timed appropriately and have interest-term conditions that are best suited to the families’ financial circumstances. Families are better off if K. C. Holden (&) La Follette School of Public Affairs, University of Wisconsin, 1225 Observatory Dr., Madison, WI 53706, USA e-mail: kcholden@wisc.edu

Deciding to Peg the Exchange Rate in Developing Countries: The Role of Private-Sector Debt

We argue that a higher share of the private sector in a country’s external debt raises the incentive to stabilize the exchange rate. We present a simple model in which exchange rate volatility does not affect agents’ welfare if all the debt is incurred by the government. Once we introduce private banks who borrow in foreign currency and lend to domestic firms, the monetary authority has an incentive to dampen the distributional consequences of exchange rate fluctuations. Our empirical results support the hypothesis that not only the level, but also the composition of foreign debt matters for exchange-rate policy.

Deciding to Peg the Exchange Rate in Developing Countries: The Role of Private-Sector Debt

We argue that a higher share of the private sector in a country’s external debt raises the incentive to stabilize the exchange rate. We present a simple model in which exchange rate volatility does not affect agents’ welfare if all the debt is incurred by the government. Once we introduce private banks who borrow in foreign currency and lend to domestic firms, the monetary authority has an incentive to dampen the distributional consequences of exchange rate fluctuations. Our empirical results support the hypothesis that not only the level, but also the composition of foreign debt matters for exchange-rate policy.

Foreign exchange pressures in Latin America: Does debt matter?

AbstractLatin American countries have been in the eye of economic and financial storms several times in recent years. Advice from the International Monetary Fund has consistently highlighted the need for sound fiscal policies and lower debt levels. But is public debt relevant? Following a brief discussion of the theoretical issues involved, this paper examines empirically the relationship between public indebtedness and pressures in the foreign exchange market. Alternative measures are used to capture the latter and the analysis controls for a de facto classification of exchange rate regimes. Estimations of static and dynamic panels for 28 Latin American and Caribbean (LAC) countries report substantial fiscal effects. Copyright © 2008 John Wiley & Sons, Ltd.

Long-Term Debt and Optimal Policy in the Fiscal Theory of the Price Level

The fiscal theory says that the price level is determined by the ratio of nominal debt to the present value of real primary surpluses. I analyze long-term debt and optimal policy in the fiscal theory. I find that the maturity structure of the debt matters. For example, it determines whether news of future deficits implies current inflation or future inflation. When long-term debt is present, the government can trade current inflation for future inflation by debt operations; this tradeoff is not present if the government rolls over short-term debt. The maturity structure of outstanding debt acts as a ‘‘budget constraint’’ determining which periods’ price levels the government can affect by debt variation alone. In addition, debt policythe expected pattern of future state-contingent debt sales, repurchases and redemptionsmatters crucially for the effects of a debt operation. I solve for optimal debt policies to minimize the variance of inflation. I find cases in which long-term debt helps to stabilize inflation. I also find that the optimal policy produces time series that are similar to U.S. surplus and debt time series. To understand the data, I must assume that debt policy offsets the inflationary impact of cyclical surplus shocks, rather than causing price level disturbances by policy-induced shocks. Shifting the objective from price level variance to inflation variance, the optimal policy produces much less volatile inflation at the cost of a unit root in the price level; this is consistent with the stabilization of U.S. inflation after the gold standard was abandoned.

Debt, growth and inflation in large European economies: a vector auto-regression analysis

This paper attempts to empirically test the hypothesis that whether debt matters in the EU. This has been performed by examining the potential adverse effects of debt in large European economies on investment, inflation and growth. Using the hybrid cointegration and vector autoregressive models, the findings, based on the period 1970–97, suggest that debt causes significant adverse effects on investment, but its impact on growth is not clear-cut. Moreover, debt appears to be inflationary in most cases in the long run, though produces no clear short run pattern on inflation.

Long-term Debt and Optimal Policy in the Fiscal Theory of the Price Level

The fiscal theory says that the price level is determined by the ratio of nominal debt to the present value of real primary surpluses. I analyze long-term debt and optimal policy in the fiscal theory. I find that the maturity structure of the debt matters. For example, it determines whether news of future deficits implies current inflation or future inflation. When long-term debt is present, the government can trade current inflation for future inflation by debt operations; this tradeoff is not present if the government rolls over short-term debt. I solve for optimal debt policies to minimize the variance of inflation. I find cases in which long-term debt helps to stabilize inflation, and I find that the optimal inflation-stabilizing policy produces time series that are surprisingly similar to US surplus and debt series.

Foreign Debt and Economic Development

This paper characterizes the optimal path of foreign public debt that can support politically unanimous (Pareto welfare improving) economic growth under uncertainty. The feasibility of the plan depends on whether the maintenance of political consensus in the debtor country requires additional loans that are high relative to the country’s outstanding debt. If a program is feasible, then the creditors will have an incentive to preserve political support for the plan, in case of adverse developments, by offering debt relief. Unlike the certainty case, where only total debt matters, uncertainty makes also the timing of debt repayments critical for economic development.

Debito pubblico versus debito privato

During the past decade several distinct ‘debt problems' have been experienced. These include the debt crisis of the less developed countries and, generally, the more recent excessive private debt. The latter-day conventional wisdom that only public debt matters is criticised. It is argued that in a world in which public debt matters, private debt is normally relevant as well. JEL Codes: F34, E21 Keywords: Public debt, Private debt

Does government debt matter? A review

Does government debt matter? A review