Seminar

Inspecting the Mechanism: Leverage and the Great Recession in the Eurozone

Philippe Martin (Sciences Po.)

March 16, 2015, 17:00–18:30

Room MS 001

Macroeconomics Seminar

Abstract

We provide a first comprehensive account of the dynamics of Eurozone countries from the creation of the Euro to the Great recession. We model each country as an open economy within a monetary union and analyze the dynamics of private leverage, fiscal policy and spreads. A parsimonious model can replicate the time-series of nominal GDP, employment, and net exports of Eurozone countries between 2000 and 2012. We then ask how periphery countries would have fared with: (i) more conservative fiscal policies; (ii) macro-prudential tools to control private leverage; (iii) a central bank acting earlier to limit financial segmentation; and (iv) effective fiscal devaluation. To perform these counterfactual experiments, we use U.S. states as a control group that did not suffer from a sudden stop. We find that periphery countries could have stabilized their employment if they had followed more conservative fiscal policies during the boom. This is especially true in Greece. For Ireland, however, given the size of the private leverage boom, such a policy would have required buying back almost all of the public debt. Macro-prudential policy would have been especially helpful in Ireland and Spain. However, in presence of a spending bias in fiscal rules, macro-prudential policies would have led to less prudent fiscal policies in the boom. If spreads had not spiked, employment would have been stabilized in all countries because they would not have been constrained into fiscal austerity. Finally, a fall in export prices - through a fiscal devaluation - would have enabled countries to attenuate the employment bust and to reduce their public debt.