Macroeconomics and Politics in the Accumulation of Greece’s Debt: An Econometric Investigation, 1975-2009

This paper focuses on an econometric investigation of the macroeconomic and political factors that contributed to Greece’s excessive debt accumulation and its failure to adequately address its fiscal imbalances, from the restoration of democracy in 1974 till the crisis of 2009. The econometric investigation is based on a model in which two political parties alternate in power, and in which governments choose primary expenditure and taxes to minimize deviations from politically determined expenditure and tax targets, subject to a debt accumulation equation. The model predicts a political equilibrium in which primary expenditure and taxes follow feedback rules which go in the direction of stabilizing the debt to GDP ratio. However, this stabilization incentive is weaker in election years. The model also predicts potential partisan differences in the evolution of primary expenditure and taxes, due to the different preferences of political parties. Estimates of government reaction functions to public debt for the period 1975-2009 suggest a rather weak stabilizing reaction of primary deficits to public debt. This stabilizing reaction disappears in election years, which are characterized by strong fiscal expansions. We find no evidence of partisan differences in the reaction of primary deficits to inherited debt, but we do find evidence of lower primary deficits in the post-1992 Maastricht treaty period. Overall the model accounts for the accumulation of Greece’s government debt in terms of the trend increase in primary expenditure, the positive shocks to primary expenditure in election years and the weak stabilizing reaction of government revenue, due to tax smoothing.

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GreeSE Paper no. 68, Hellenic Observatory, London School of Economics

Discussion Paper no. 10-13, Department of Economics, Athens University of Economics and Business

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Assessing Deviations from Ricardian Equivalence in an Endogenous Growth Model

This paper proposes a method for assessing the quantitative significance of deviations from the Ricardian equivalence hypothesis. The model proposed for this purpose belongs to a class of endogenous growth theories with investment adjustment costs, in which savings and investment are co-determined through adjustments in the real interest rate. The equilibrium investment rate determines the long-run growth rate, because of constant returns to capital accumulation due to externalities of the “learning by doing” type. We set up and compare two versions of the model, one with a representative household, in which Ricardian equivalence holds, and one with overlapping generations, in which it does not. We calibrate the two versions of the model using common parameter values and assess the significance of deviations from Ricardian equivalence in the overlapping generations model. For plausible parameter values, the differences in growth rates are of the order of 0.2 to 0.3 of a percentage point per annum, which accumulated over twenty five years are between 5.1%-7.8% of aggregate output. Neither growth rates nor interest rates appear to be particularly sensitive to the aggregate debt to output ratio. A rise of the debt to output ratio from 60% to 200% of aggregate output results in a decrease in the growth rate of about 0.03 of a percentage point, which accumulated over twenty five years is less than 1% of aggregate output. The differences for real interest rates are even smaller. Overall the results suggest that Ricardian equivalence is a relatively good approximation to reality, and the relative simplicity of the representative household model does not lead to predictions that would be too far off quantitatively, even if the world is characterized by overlapping generations.

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Savings, Investment and the Real Interest Rate in an Endogenous Growth Model

This paper compares the predictions of representative household models with those of models of overlapping generations, in the context of a class of endogenous growth theories with investment adjustment costs. In the model used in this paper, savings and investment are co-determined through adjustments in the real interest rate, and the equilibrium investment rate determines the long-run growth rate. The two classes of models have similar predictions regarding the effects of technological and preference shocks, but the overlapping generations model results in lower savings and investment, higher interest rates and lower growth rates that the corresponding representative household model. We calibrate the two models using similar parameter values and the results suggest that the differences between the two models are not quantitatively large. For plausible parameter values, the differences in growth rates, savings rates and investment rates are of the order of 0.1 to 0.2 of a percentage point per annum, which accumulated over twenty five years is at most 5% of aggregate output. The differences for real interest rates are even smaller. Overall the results suggest that the relative simplicity of the representative household model does not lead to results that would be too far off quantitatively, even if the world is characterized by overlapping generations.

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Working Paper 17-2012 Department of Economics AUEB

 

Government Debt, The Real Interest Rate, Growth and External Balance in A Small Open Economy

This paper examines the effects of government debt policies with imperfect substitutability between securities issued by different countries. It puts forward an intertemporal model of a small open economy to analyze the effects of government debt on the real interest rate, economic growth, private consumption and the balance of payments. The model is an endogenous growth, overlapping generations model with convex adjustment costs for investment, and imperfect substitutability between domestic and foreign bonds. It is shown than an increase in the government debt to output ratio causes the spread between the domestic and the foreign real interest rate to rise and the endogenous growth rate to fall. In addition, when domestic government bonds are relatively close substitutes for foreign bonds, the rise in government debt causes a temporary rise in domestic consumption, as current generations view government debt as wealth. The current account moves into deficit, the economy decumulates net foreign assets, and in the new long run equilibrium both the consumption to output ratio and net foreign assets as a proportion of output fall. When domestic government bonds are not close substitutes for foreign bonds,  the rise in government debt causes a temporary fall in domestic consumption, as the negative real interest rate effect of the rise in government debt dominates the wealth effect. In this case the current account improves and in the new long run equilibrium both the consumption to output ratio and net foreign assets as a proportion of output rise.

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Discussion Paper no. 9-13, Department of Economics, Athens University of Economics and Business

 

 

Money, Growth and External Balance in a Small Open Economy

This paper puts forward an intertemporal model of a small open economy to analyze the effects of money, government debt and real shocks on growth, inflation and external balance. The model is an endogenous growth, overlapping generations model, with money in the utility function, convex adjustment costs for investment, and perfect substitutability between domestic and foreign bonds. It is shown that the growth rate depends only on the world real interest rate, the productivity of domestic capital, the adjustment cost parameter for investment and the depreciation rate. It does not depend on money, budgetary policies or the preferences of domestic consumers. Consumption of goods and services and external balance, in addition to the world real interest rate and the domestic productivity of capital, depend on money, budgetary policies and the preferences of domestic consumers. The model is used to analyze the full effects of real and monetary shocks. Monetary growth is not superneutral in this model, as it affects domestic consumption and the net foreign position of the economy.

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Working Paper 16-2012 Department of Economics AUEB

 

Endogenous Growth and External Balance in a Small Open Economy

This paper puts forward an intertemporal model of a small open economy which allows for the simultaneous analysis of the determination of endogenous growth and external balance. The model assumes infinitely lived, overlapping generations that maximize lifetime utility, and competitive firms that maximize their net present value in the presence of adjustment costs for investment. Domestic securities are assumed perfect substitutes for foreign securities and the economy is small in the sense of being a price taker in international goods and assets markets. The endogenous growth rate is determined solely as a function of the determinants of domestic investment, such as the world real interest rate, the technology of domestic production and adjustment costs for investment. The endogenous growth rate is independent of domestic savings and the preferences of consumers. Given the domestic growth and investment rate, the preferences of consumers determine the current account and external balance. The model can also be used to analyze the implications of budgetary policy. The world real interest rate affects growth negatively but has a positive impact on external balance. The productivity of domestic capital affects growth positively but causes a deterioration in external balance. Government consumption and government debt affect the current account and external balance negatively, but do not affect the endogenous growth rate. This model addresses and resolves the indeterminancy problems that arise in comparable representative household endogenous growth models of small open economies.

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Working Paper 15-2012 of Department of Economics AUEB

Greece’s Sovereign Debt Crisis: Retrospect and Prospect

This paper provides an analysis and assessment of the Greek sovereign debt crisis, and examines alternative solutions to the problem. In order to put the current fiscal predicament of Greece in perspective and discuss how the Greek debt crisis might possibly be resolved, the paper first provides a detailed account of how the sovereign debt of Greece was accumulated and then stabilized relative to GDP. It then proceeds with an account of how the international financial crisis led to a de- stabilization of Greece’s sovereign debt, and with an assessment of the adjustment program currently in operation. We address the question of solvency, and whether the current program is sufficient for the resolution of Greece’s debt crisis. The paper concludes with proposals for tackling the confidence crisis and speeding up the recovery of the Greek economy.

GreeSE Paper no 54, Hellenic Observatory, London School of Economics