Structural reforms in a debt overhang

Transcription

1 Srucural reforms in a deb overhang PRELIMINARY, PLEASE DO NOT CIRCULATE Javier Andrés Universiy of Valencia Óscar Arce Banco de España April 14 Carlos Thomas Banco de España Absrac We assess he effecs of reforms in produc and labor markes in a model economy undergoing a slow and proraced deleveraging of he privae secor. We argue ha he conjuncion of widespread credi resricions and preexising long-erm deb, which are core feaures of he curren deleveraging processes faced by some euro area counries, miigae he shor-erm coss associaed o he disinflaionary effecs ypically caused by reforms. We show ha, in an environmen of slow deleveraging, produc and labour markes reforms may simulae oupu and employmen even in he shor run, in par by bringing forward he end of he deleveraging phase. Keywords: deleveraging, collaeral consrains, long-run deb, srucural reforms JEL codes: E43, E44, E65, G1 javier.andres@uv.es o.arce@bde.es carlos.homas@bde.es Disclaimer: The views expressed herein are hose of he auhors and no necessarily hose of he Banco de España or he Eurosysem. 1

2 1 Inroducion Weak domesic demand and heighened vulnerabiliy o adverse perurbaions have become pervasive feaures of he macrofinancial landscape in some European counries, in a conex dominaed by high levels of indebedness of non-financial corporaions and households. This is he case of he periphery of he euro area, where deb o GDP raios are sill only marginally below hisorical highs, as deleveraging, hindered by poor growh raes, is aking place very slowly, as illusraed in Figure 1. For hese counries, he lack of room for maneuver o apply expansionary fiscal and (convenional) moneary policies is drawing a scenario of proraced privae secor deleveraging amid low economic growh, wih few policy opions o bring some relief. Among he available opions, srucural reforms in produc and labor markes have araced much aenion by governmens, mulilaeral bodies and commenaors. In paricular, in offi cial circles a consensus has arisen over he recen years on he desirabiliy of making markes more effi cien in order o increase he overall compeiiveness of he weakes European economies. 1 Common wisdom suggess ha inernal devaluaion processes, favored by lower and/or more flexible prices and wages, should help he exporing secor lead he recovery in he shor erm, compensaing for weak domesic demand. Likewise, from a longer erm perspecive, growh poenial should benefi from more compeiive markes. The resuling permanen income effecs should also impac posiively on curren expendiure decisions by forward-looking households and firms (expecaions channel). However, in an environmen of high privae deb and lack of margin for expansionary moneary and fiscal policies, more compeiive markes, via negaive pressures on prices and wages, are likely o unchain some conracionary forces in he shor erm arising from higher real ineres raes and deb-deflaion effecs (deflaionary channel). Which of he wo forces -inernaional compeiiveness and expecaions versus deflaionary channel- dominaes remains an open quesion and, hence, in principle, well-inended reforms could end up worsening he recession and posponing he recovery. This paper ries o shed ligh on his issue. To his aim, we consruc a macroeconomic model upon wo core elemens ha are suggesed by he recen experience of he European periphery counries: (i) a widespread ighening of he financing condiions faced by households and firms, and (ii) a slow and proraced process of privae secor deleveraging. In paricular, we build a general equilibrium model of a small open economy inside a moneary union. Households and enrepreneurial firms ( enrepreneurs for 1 See e.g. OECD (1), European Commission (13) and Inernaional Moneary Fund (13).

3 14 Greece Ireland Ialy Porugal 16 4 Spain Privae deb/gdp (pp) GDP ( = 1, righ scale) Source: AMECO, BIS and auhors' calculaions Figure 1: Deleveraging and GDP in he EMU periphery shor) obain new credi subjec o collaeral consrains, such ha heir ousanding deb canno exceed a fracion ( loan-o-value ) of he value of collaeralizable asses, as in Kiyoaki and Moore (1997). As in Iacoviello (5), real esae is he only pledgeable asse. A key poin of deparure from hese papers, aimed a producing an empirically plausible slow deleveraging pah, is ha we consider long erm deb conracs. Specifically, in he spiri of Woodford (1) we assume ha nominal deb ousanding is amorized a a consan conracual rae. This creaes an asymmery in he dynamics of he deb sock. In normal imes in which collaeral values are suffi cienly high so as o allow for new credi flows, he value of available collaeral resrics he size of he deb sock. By conras, following an adverse shock ha reduces debors collaeral values suffi cienly, new credi is frozen and ousanding loans are amorized mechanically a he conracual rae. Therefore, he model feaures a double deb regime, and he economy may swich endogenously from one regime o he oher as collaeral values fall below or rise above he hresholds ha jusify new credi flows. In addiion, he model feaures sandard real and nominal rigidiies. In paricular, produc and labor markes are characerized by monopolisic compeiion and here is saggered adjusmen of price and wages. Finally, he assumpion of a small economy wihin a moneary union implies ha he nominal ineres rae of he moneary auhoriy is aken as exogenous by he domesic economy. This, in urn, resembles a scenario akin o a siuaion in which he nominal ineres rae his is zero lower bound (ZLB). 3

4 In order o consruc a baseline deleveraging scenario moivaed by he financial origin of he recen crisis, we inroduce a credi crunch shock ha akes he form of an unexpeced and permanen fall in he loan-o-value raios of boh households and enrepreneurs. The shock produces a sharp fall in real esae prices. As a resul, collaeral values fall below he hresholds ha jusify fresh lending flows and he economy eners ino a deb regime in which gross new credi sops and he sock of deb decays a he conracual amorizaion rae. The credi freeze depresses domesic demand. The ensuing fall in prices and he resuling improvemen in inernaional compeiiveness lead o an increase in expors, which parially couneracs he fall in domesic demand. However, he posiive conribuion from he exernal secor is no suffi cien o avoid a recession ha exends over several years. A some poin, asse prices recover suffi cienly o jusify new credi flows. This gives rise o an expansionary phase, characerized by a viruous circle of higher borrowers ne worh, increasing asse prices and new lending, ha ulimaely lead o posiive growh and higher employmen. Imporanly, he ime a which he economy swiches from he deleveraging phase o he recovery one is endogenous. We hen simulae he effecs of srucural reforms agains he backdrop of he baseline deleveraging scenario jus discussed. In paricular, we consider unexpeced, permanen reducions in desired price and wage markups, aimed a capuring he poenial beneficial effecs of srucural reforms ha enhance compeiion in produc and labor markes. As one would expec, boh ypes of reforms produce long run gains in GDP. More ineresingly, we also find ha boh reforms miigae he shor-run oupu and employmen losses caused by he deleveraging shock. This is especially rue for he produc marke reform, reflecing he fac ha reducions in desired price markups have a quicker effec on acual producion prices (and hence on inernaional compeiiveness) han comparable reducions in desired wage markups ha, in order o deploy heir full effecs, mus overcome a double layer of nominal rigidiies (price and wages). Moivaed by his las observaion, we also consider a broader labor marke reform ha, in addiion o lowering desired wage markups, allows also for a faser adjusmen of nominal wages owards heir flexible-wage levels. Such a reform is shown o have posiive effecs on economic aciviy already in he very shor run. Imporanly, in he case of he produc marke, he shor and medium run gains produced by he reform are amplified by he endogenous shorening of he delivering In paricular, under our baseline calibraion he produc marke reform has sizable posiive effecs on oupu and employmen already on he same quarer in which he reform is implemened. The labor marke reform is essenially neural on impac and posiive one quarer laer, wih he posiive effecs increasing gradually. 4

5 phase. In paricular, he long-run posiive effecs on economic aciviy in he reform scenario lead o a less severe fall in (forward-looking) asses prices, and hence in collaeral values. As a resul, he laer cach up earlier wih he hreshold levels ha allow borrowers o regain access o new credi. Ineresingly, he anicipaion of an earlier recovery of he credi flow leads borrowers o save and inves more oday which furher conribues o a faser rebuilding of heir ne worh. Through his self-reinforcing mechanism, he produc marke reform brings forward he end of he deleveraging phase and hence of he recession. For boh ypes of reforms, he foreign secor plays an imporan role in shaping he shor-run effecs. In his regard, we show ha higher elasiciies of expors and impors wih respec o he erms of rade lead o larger shor-run gains from reforms. On he oher end, we find ha labor marke reforms based only on lower wage markups may lead o negaive shor-run effecs on GDP and employmen if price elasiciies of expors and impors are low. This suggess ha he shor-run effecs of srucural reforms will depend o a large exen on he inensiy wih which he resuling gains in inernaional compeiiveness carry over o acual rade flows. Our framework offers a more posiive view on he macroeconomic effecs of srucural reforms han he one prescribed by a sandard New Keynesian framework ha absracs from financial fricions, such as he one employed by Eggersson, Ferrero and Raffo (14). These auhors argue ha higher compeiion in produc and labor markes may be conracionary if moneary policy is consrained by he zero lower bound, due o he deflaionary impac of he reforms. In our model, reforms are deflaionary as well, bu he resuling negaive shor-run effecs are dominaed by he posiive effecs from he reforms. The difference in he assessmen can be raced back o he financial apparaus conained in our model, namely credi consrains and long-erm deb. Boh elemens work owards reducing he inensiy of he (negaive) deflaionary shor-erm effec during he deleveraging process. Firs, he fac ha borrowers do no obain new credi and simply amorize heir debs a he conracual rae implies ha he reform-driven increase in real ineres rae has lile effec on domesic demand. Second, since under long-erm conracs debors pay back only a small (firs order) fracion of heir ousanding deb each period, he deflaion produced by he reform has a second order effec on borrowers ne deb flows and hence on heir spending capaciy. Fernández-Villaverde, Guerrón-Quinana and Rubio-Ramírez (1) also sudy he effecs of supply-side reforms when moneary policy is consrained by he ZLB in he conex of a sylized wo-period New Keynesian model. They offer some quaniaive examples showing ha credible announcemens of fuure increases in produc marke compeiion unchain posiive wealh effecs ha may raise consumpion and 5

6 oupu oday. In he conex of a fully dynamic open-economy model wih financing consrains and long-run deb, we show ha increases in produc and labor marke compeiion may deliver shor-run gains in oupu even if implemened unexpecedly. We hus show ha he ensuing deflaionary impac of reforms invoked by Eggersson e al. (14) may no be suffi cien per se o undo heir shor run posiive effecs, even when he deb-deflaion channel is presen. Galí and Monacelli (14) analyze he employmen effecs of a emporary reducion in payroll axes (which has similar effecs o hose of a conracion in desired wage markups) in he conex of a sandard New Keynesian small open economy model. They find ha he impac of wage adjusmens on employmen is smaller he more he cenral bank seeks o sabilize he exchange rae. Here we consider a small open economy inside a moneary union, and hus we do no sudy he ineracion beween srucural reforms and he degree of moneary policy accommodaion. Insead, we focus on he effecs of such reforms, when implemened on a permanen basis, in a conex of slow and proraced privae secor deleveraging, showing ha produc marke reforms and (broad) labor marke reforms may yield sizeable shor-run gains in economic aciviy and employmen. More generally, our paper also conribues o he growing lieraure focused on deleveraging processes. Fornaro (1) and Benigno and Romei (1) obain a sharp, hough shor-lived, drop in oupu and employmen afer a negaive financial shock in an economy wih nominal ineria, fixed exchange raes and a consan nominal ineres rae. Guerreri and Iacoviello (14) find ha recessions driven by asse price deflaions have a significan negaive impac on spending and oupu. Eggersson and Krugman (1), and Calvo, Coricelli, and Oonello (1) find similar effecs of deleveraging on oupu and employmen. Our paper also sheds ligh on some of hese issues alhough i differs wih respec o is moivaion, which here is on he impac of srucural reforms, and wih respec o some modeling assumpions, especially, he one concerning long-erm deb, which is a cenerpiece in our analysis. Regarding his las issue, Jusiniano, Primiceri and Tambaloi (13) also consider he exisence of long-erm deb in a se up in which a deleveraging shock has a relaively minor effec on economic aciviy, as i gives rise o a wealh redisribuion effec from debors o crediors ha, in ne erms, almos washes ou a he aggregae level. Besides argeing a differen moivaing quesion, our model gives rise o a deleveraging scenario ha enails a proraced and very cosly recession, in line wih he evidence summarized by Reinhar and Rogoff (9). The paper is organized as follows. The model and he calibraion are presened in Secion.The baseline scenario is analyzed in Secion 3. Secion 4 is devoed o analyze he impac of several reforms in he produc and labor markes. Secion 5 6

7 concludes. Model We now presen a general equilibrium model of a small open economy, which belongs o a moneary union. The real side of he economy is fairly sandard. Households obain uiliy from consumpion goods and from housing unis. Consumpion goods are produced using a combinaion of household labor, commercial real esae and equipmen capial goods. Consrucion firms build real esae (boh for residenial and commercial purposes) using labor and consumpion goods; he laer are also used as inpus by equipmen capial goods producers. Final goods and labor markes are boh characerized by monopolisic compeiion and nominal rigidiies. On he financial side, he srucure is as follows. Consrained households and enrepreneurs are more impaien han unconsrained households and hus become borrowers in equilibrium, whereas unconsrained households become lenders. In normal imes (in a sense o be specified below), borrowing by consrained households and enrepreneurs is subjec o sandard collaeral consrains, as in Kiyoaki and Moore (1997). Tha is, heir indebedness is limied o a cerain fracion of he expeced value of heir collaeral: residenial propery for households, commercial real esae for enrepreneurs. Unlike in mos of he lieraure, hough, we assume ha deb conracs are long-erm. As we will see, his creaes an asymmery in he effecive deb limi faced by borrowers. In paricular, in periods in which collaeral values are suffi cienly low, he laer no longer resric he sock of deb ousanding, which is insead amorized a a consan conracual rae. This implies ha he economy may swich beween boh deb regimes in response o shocks ha affec collaeral values. All variables are in real erms unless oherwise specified, wih he consumpion goods baske acing as he numeraire..1 Households There is a represenaive consrained household and a represenaive unconsrained household, denoed respecively by c and u..1.1 Cos minimizaion Before analyzing dynamic household opimizaion, we firs look a he saic cos minimizaion problem, which is common o boh households ypes. Households con- 7

8 sume a baske of home and foreign goods, denoed respecively by H and F, ( c x = ω 1/ε ( ) H H c x (εh 1)/ε H H, + (1 ω H ) 1/ε ( ) ) H c x (εh 1)/ε εh /(ε H 1) H F,, (1) where c x H, is a baske of domesic good varieies, ( 1 c x H, = ) ε p c x /(εp 1) H, (z) (εp 1)/εp dz, () where ε p > 1 is he (exogenously ime-varying) elasiciy of subsiuion across consumpion varieies. Le P H, (z) denoe he nominal price of home good variey z, and P F, he nominal price of he foreign goods baske. Household x = c, u minimizes nominal consumpion expendiure, 1 P H, (z) c x H, (z) dz +P F,c x F,, subjec o (1) and (). The firs order condiions can be expressed as c x H, = ω H ( PH, P ) εh c x, (3) for each z [, 1], where c x F, = (1 ω H ) ( PF, P H, P ) εh c x, (4) ( ) ε p c x PH, (z) H, (z) = c x H,, (5) P = ( ω H P 1 ε H H, is he consumer price index (CPI), and ) + (1 ω H ) P 1 ε 1/(1 εh ) H F, ( 1 P H, = ) 1/(1 ε p ) P H, (z) 1 εp dz (6) is he producer price index (PPI). Nominal spending in domesic goods equals 1 P H, (z) c x H, (z) dz = P H, c x H,, whereas oal nominal consumpion spending equals P H,c x H, + P F,c x F, = P c x. As noed before, consumpion goods are also used as inpus by consrucion firms and equipmen capial producers. The laer are assumed o combine home and foreign goods analogously o households, and similarly for domesic good varieies. This gives rise o invesmen demand funcions analogous o (3)-(5). 8

9 .1. Unconsrained households The unconsrained household maximizes } 1 E (β u ) {log (c u ) + ϑ log (h u n u (i) 1+ϕ ) χ 1 + ϕ di, = where n u (i) are labor services of ype i [, 1] and h u are housing unis, subjec o he following budge consrain (expressed in unis of he consumpion goods baske), c u + d + p h [ h u (1 δ h ) h 1] u R 1 1 = d 1 + π W (i) n u (i) di, P where d is he real value of ne holdings of inernaional nominal bonds, R is he gross nominal ineres rae on inernaional bonds, 3, δ h is he depreciaion rae of real esae, p h is he real price of real esae, π P /P 1 is gross CPI inflaion, and W (i) is he nominal wage for labor services of ype i. The firs order condiions are sandard; hey are lised in he Appendix, ogeher wih all oher equilibrium condiions..1.3 Consrained households The consrained household maximizes } 1 E β {log n c (i) 1+ϕ (c ) + ϑ log (h ) χ 1 + ϕ di, = where β < β u (i.e. he consrained household is relaively impaien), subjec o he following budge consrain, c + R 1 1 b 1 + p h [h (1 δ h ) h 1 ] = b + π W (i) n c (i) di, P where b is he real value of nominal household deb ousanding a he end of period. 3 In order o guaranee saionariy in he ne foreign asse posiion, we assume R = R exp( ψnfa y ), where R is he world gross nominal ineres rae and nfa y fracion of GDP (o be derived below). is he ne foreign asse posiion as a 9

10 Maximizaion is also subjec o borrowing consrains. Unlike in mos of he lieraure, which ypically assumes shor-erm (one-period) deb, we assume ha deb conracs are long-erm. In he ineres of racabiliy, we assume ha a he beginning of ime he household repays a fracion 1 γ of all nominal deb ousanding a he end of period 1, regardless of when ha deb was issued. This ype of perpeual deb is similar o he one proposed by Woodford (1) as a racable way of modelling long-erm deb. In real erms, he ousanding principal of household deb hen evolves as follows, b = b 1 π + b new (1 γ) b 1 π = b new + γ b 1 π, where b new denoes new deb issuance ne of volunary amorizaions, i.e. amorizaions beyond he conracual deb repaymen (1 γ) b 1 /π. When choosing end-of-period deb b, he household is subjec o collaeral consrains, as in Kiyoaki and Moore (1997). In paricular, as in Iacoviello (5) ousanding deb b canno exceed a fracion m (he loan-o-value raio ) of he expeced discouned value of he household s residenial sock, R 1 E π +1 p h +1h. Imporanly, his deb limi is only effecive as long as i exceeds γb 1 /π. Indeed, if m R 1 E π +1 p h +1h falls below γb 1 /π, lowering b o he value of collaeral would require b new <. Tha is, besides seing gross new credi o zero (is lower bound), lenders would have o impose addiional amorizaions beyond hose agreed in he conrac. Since lenders canno force borrowers o pay back faser han he conracual amorizaion rae, he deb limi is replaced by γb 1 /π. Therefore, long run deb implies he following asymmeric borrowing consrain, b R 1 m E π +1 p h +1h, if m E π +1 p h R +1h γ b 1, (7) π b γ b 1 π, if m R E π +1 p h +1h < γ b 1 π. (8) This asymmery gives rise o a double deb regime. In normal imes in which collaeral values exceed he conracual amorizaion pah γb 1 /π, deb is resriced by he former. In his baseline regime, households can issue new credi agains heir housing collaeral, wih he consrain ha b new m R 1 E π +1 p h +1h γb 1 /π. However, in he face of shocks ha reduce collaeral values suffi cienly, he economy may swich o an alernaive regime, in which deb is resriced insead by he conracual amorizaion pah. 1

11 The firs order condiions of his problem are given by 1 c = βe R π +1 1 c +1 + ξ 1 (ϑ ) +µ 1 (ϑ < ) βγe µ +1 π +1 1 (ϑ +1 < ), p h = ϑ (1 δ h ) p h +1 m + βe + ξ c h c E π +1 p h +1 R +11 (ϑ ), where ξ and µ are he Lagrange mulipliers associaed o consrains (7) and (8) respecively, 1 ( ) is he indicaor funcion, and ϑ R 1 m E π +1 p h +1h γb 1 /π. Noice ha in he baseline regime wih collaeral consrains (ϑ ), he marginal value of housing is higher due o he possibiliy of borrowing agains i. This possibiliy disappears once he economy eners ino he alernaive regime.. Producion Enrepreneurs produce an inermediae good and sell i o reailers, who ransform i ino consumpion good varieies. Enrepreneurs and reailers conform he consumpion goods secor. In addiion, consrucion firms produce real esae, boh for residenial and commercial use, whereas equipmen capial is produced by capial goods producers. All secors operae under perfec compeiion, excep reailers who enjoy monopolisic power...1 Enrepreneurs A represenaive enrepreneur produces an inermediae produc and sells i o reailers a a perfecly compeiive real (CPI-deflaed) price mc. The enrepreneur maximizes subjec o E = β log c e, c e + R [ b e π 1+p h h e (1 δ h ) h 1] e +q [k (1 δ k ) k 1 ] = mc y e W n e P +b e + Π s, s=r,h,k y e = k α k 1 ( h e 1 ) αh (n e ) 1 α k α h, where y e is oupu of he inermediae good, k 1 is equipmen capial, δ k is he depreciaion rae of equipmen capial, h e 1 is commercial real esae, n e is a baske 11

12 of labor services, W is a nominal wage index, b e is he real value of nominal enrepreneurial deb ousanding a he end of period, and {Π s } s=r,h,k are real profis from he reail, consrucion and equipmen goods-producing secors. Noice ha enrepreneurs are assumed o own he firms in he laer secors. We adop his specificaion because we are ineresed in analyzing how profi accumulaion affecs producive invesmen decisions, which in our model are made by he enrepreneurs. Enrepreneurs maximizaion is also subjec o an asymmeric borrowing consrain analogous o he one on consrained households, b e R 1 m e E π +1 p h +1h e, if me E π +1 p h R +1h e γ e be 1, (9) π b e γ e be 1 π, if me R E π +1 p h +1h e < γ e be 1 π, (1) where we allow for a differen loan-o-value raio (m e ) and conracual amorizaion rae (1 γ e ) for enrepreneurs. The Appendix liss he firs-order condiions of his problem. Here we derive he opimal demand for commercial real esae, p h c e = βe mc +1 α h y e +1/h e + (1 δ h ) p h +1 c e +1 + ξ e m e R E π +1 p h +11 (ϑ e ), where ξ e is he Lagrange mulipliers associaed o consrain (9), and ϑ e R 1 m e E π +1 p h +1h e γ e b e 1/π. Analogously o he case of consrained households, in he baseline regime wih collaeral consrains (ϑ e ) he marginal value of commercial real esae is higher hanks o he possibiliy of borrowing agains i... Reailers A coninuum of monopolisically compeiive reailers indexed by z [, 1] purchase he inermediae inpu from enrepreneurs a he real price mc, and ransform i one for one ino final good varieies. Reailers real marginal cos is hus mc. Each reailer z faces a demand curve ( ) ε p PH, (z) y (z) = y y d (P H, (z)), (11) P H, where y is aggregae demand of he consumpion baske (o be defined below). Assuming Calvo (1983) price-seing, a reailer ha has he chance of seing is nominal price a ime solves [ ] max E (βθ p ) s c e PH, (z) mc +s y+s d (P H, (z)), P H, (z) s= c e +s P +s 1

13 where θ p is he probabiliy of no adjusing he price. The firs-order condiion is E s= (βθ p ) s c e c e +s ( (ε p +s 1) P H, P +s ε p +smc +s ) P ε p +s H,+s P εp +s +1 H, y +s =, where P H, is he opimal nominal price chosen by all ime- price seers. In he case of flexible prices (θ p = ), we have P H, = εp ε p 1P mc, i.e. reailers charge a markup ε p / (ε p 1) over marginal coss; herefore, he markup facor ε p / (ε p 1) measures he degree of monopolisic disorions in produc markes. Reailers aggregae real profis are 1 ( ) ( ) Π r PH, (z) PH, mc y (z) dz = y mc, P P where we have used (6) and where 1 is an index of relaive price dispersion...3 Consrucion firms ( ) εp PH, (z) dz (1) P H, A represenaive consrucion firm maximizes is expeced discouned sream of profis, λ e E Π h λ e ( = E p h I h W ) n h i h, P = λ e subjec o he producion echnology I h = ( { ) n h ω i h [ = λ e 1 Φ h ( i h i h 1 1) ]} 1 ω, (13) where n h are labor services, i h are consumpion goods, and I h are new real esae unis. 13

14 ..4 Equipmen capial producers A represenaive equipmen capial producer maximizes E λ e λ e = Π k = E λ e λ e = (q I i ) subjec o he echnology I = i [ 1 Φ ( ) ] i 1, i 1 where i are consumpion goods, and I are new equipmen capial goods..3 Wage seing Boh enrepreneurs and consrucion firms use a baske of labor services by consrained and unconsrained households, n s = (n s,c ) µ s (n s,u ) 1 µ s, where n s,x are labor services provided by ype-x household, x = c, u, o each secor s = e, h. We assume ha boh worker ypes (consrained and unconsrained) earn he same wage. Cos minimizaion hen implies (1 µ s ) n s,c = µ s n s,u, for s = e, h. From each household ype, each secor demands in urn a baske of labor service varieies, ( 1 εw /(εw n s,x = n s,x (i) (εw 1)/εw di) 1), for x = c, u and s = e, h, where ε w > 1 is he (exogenously ime-varying) elasiciy of subsiuion across labor varieies. Demand for each labor variey by each secor of producion is hus given by n s,x (i) = ( W (i) W ) ε w n s,x, 14

15 for x = c, u and s = e, h, where ( 1 W W (i) 1 εw ) 1/(1 ε w ) di is he nominal wage index. Toal demand for each variey i of labor services is hus n x (i) n e,x (i) + n h,x (i) = ( W (i) W ) ε w ( n e,x ) + n h,x n d,x (W (i)), (14) for x = c, u. Toal nominal wage income earned by each ype-x household equals 1 W (i) n x (i) di = W n x, where n x n e,x + n h,x. As in Erceg, Henderson and Levin (; EHL), nominal wages are se à la Calvo (1983). In paricular, a union represening all ype-i workers maximizes he uiliy of he households o which such workers belong. Le λ x 1/c x denoe he marginal uiliy of real income for each household ype x = c, u, wih c c = c. Then a union ha has he chance o rese he nominal wage a ime chooses W (i) o maximize ( ) 1+ϕ E (β x θ w ) s λ x W (i) n d,x +s n d,x +s (W (i)) +s (W (i)) χ, P +s 1 + ϕ x=c,u s= where θ w is he probabiliy of no adjusing he wage and β c = β. The firs-order condiion is x=c,u E s= [ (ε (β x θ w ) s w +s 1 ) W λ x +s ε w P +sχ +s ] ( ( )) ϕ n d,x +s W W εw +s +s W εw +s +1 n x +s =, where W is he opimal wage chosen by all ime- wage seers. In he case of flexible prices, workers charge a markup ε w / (ε w 1) over a weighed average of consrained and unconsrained households marginal rae of subsiuion beween consumpion and labor. Therefore, he markup facor ε w / (ε w 1) measures he degree of monopolisic disorions in he labor marke..4 Foreign secor A represenaive exporer produces he following baske of domesic consumpion goods: x = ( 1 x (z) (εp 1)/εp dz) εp /(εp 1), where x (z) is demand for each domesic good variey. Cos minimizaion implies ha he exporer s demand for each variey 15

16 is x (z) = (P H, (z) /P H, ) εp x, and oal spending is 1 P H, (z) x (z) dz = P H, x. The exporer sells he baske x in expor markes under perfec compeiion. The zero profi condiion implies ha he marke price of he expor baske is exacly P H,. Assuming ha foreign consumers preferences are analogous o hose of domesic consumers, foreign demand for he baske of domesic goods is given by x = ζ ( PH, P F, ) εf y F,, where P F, and y F, are he foreign price level and aggregae demand (boh exogenous) and ε F is he price elasiciy of expors. Defining he erms of rade p P H, /P F,, he laer evolve according o p = p 1π H, /π F,,where π F, P F, /P F, 1 is foreign inflaion..5 Aggregaion and marke clearing Each reailer z demands y d (P (z)) unis of he inermediae inpu, as given by (11). Toal demand for he laer equals 1 yd (P (z)) dz = y, wih defined in (1). Marke clearing in he inermediae good marke hus requires k α k 1 ( h e 1 ) αh (n e ) 1 α h α k = y. As noed before, invesmen-goods producers and exporers demand he same combinaion of domesic consumpion goods as consumers. Therefore, aggregae demand for he baske of domesic consumpion goods is given by, y = c c H, + c u H, + c e H, + i H, + i h H, + x. (15) Toal demand for real esae mus equal oal supply, h + h u + h e = I h + (1 δ h ) ( h 1 + h u 1 + h e 1). Toal demand for equipmen capial mus equal oal supply, Labor marke clearing requires k = I + (1 δ k ) k 1. n c + n u = n e + n h. 16

17 This complees he model. We may combine all marke clearing condiions and budge consrains o obain he curren accoun ideniy (which is redundan as a resul of Walras Law), nfa = R nfa 1 + P H, x P F, π P P ( ) c c F, + c u F, + c e F, + i F, + i h F,, where nfa d b b e is he real (CPI-deflaed) ne foreign asse posiion. We finally define real (PPI-deflaed) GDP as gdp y + P (q I i ) + P ( ) p h P H, P I h i h H, = P c o + P ( q I + p h I h P H, P H, where in he second equaliy we have used (15) and z H, = c c, c u, c e, i, i h, and where c o impors c o F, GDP is hen simply nfa y P nfa /P H, gdp..6 Calibraion ) + [x P F, P H, ( c o F, + i F, + i h F,) ], P P H, z P F, P H, z F, for x = c e + c u + c e is oal consumpion (oal consumpion are defined analogously). The ne foreign asse posiion as a fracion of For he purpose of illusraion, we calibrae he model o he Spanish economy. The ime period is a quarer. We mach he model s seady sae o a number of empirical arges in 7, he year prior o he sar of he financial crisis. We do no claim, however, ha he Spanish economy was in (or close o) a seady sae in 7. Insead, our model s seady sae should be inerpreed as he economy s iniial condiion for he purpose of our simulaion exercises. The discoun facor for consrained households is se o β =.98. For unconsrained households, we choose β u = 1.5 1/4, which is consisen wih a seady sae real ineres rae of R ss /π ss = 1.5 1/4, where R ss = R e ψ(nfay ss). We se world inflaion o π F,ss = 1, which implies π H,ss = π ss = 1 in a saionary equilibrium. Choosing R = 1. 1/4 for he world nominal ineres rae, we hen se ψ o replicae ne foreign asses over GDP in 7, nfa y ss = The inverse labor supply elasiciy is se o ϕ = 4, consisenly wih a large body of micro evidence. The weigh parameer in he consumpion baske, ω H, is se o mach gross expors over GDP in 7 (6.9). Based on evidence for Spain in García e al. (9), he price elasiciy of expors and impors is se o ε F = ε H = 1. The scale parameer in expor demand, ζ, is chosen such ha seady-sae erms of rade p ss are normalized o 1. 17

18 The elasiciies of subsiuion across varieies of consumpion goods and labor services, ε p and ε w, conrol he degree of marke power in produc and labor markes, respecively. We se ε p = 7, implying an iniial price markup of ε p /(ε p 1) = 1.17, which is broadly consisen wih esimaes by Monero and Urasun (13) based on Spanish firm-level daa. Wage markups are hard o esimae empirically, so we adop an alernaive calibraion sraegy. We follow Galí (1) in reinerpreing he EHL model of wage-seing in a way ha delivers equilibrium unemploymen (see Appendix B for deails). Targeing an unemploymen rae of 8.6 in 7, we obain ε w = 3.31, i.e. an iniial wage markup of ε w /(ε w 1) = The elasiciy of consumpion oupu wih respec o equipmen capial and commercial real esae are se o α k =.1 and α h =.19, which are chosen o replicae he labor share of GDP in 7 (61.6) and he share of equipmen capial in he oal sock of producive capial. 4 As in Iacoviello and Neri (1) we se δ h =.1, whereas δ k is se o a sandard value of.5. The elasiciy of consrucion oupu wih respec o labor ω is se o mach he consrucion share of oal employmen in 7 (13.4). The weigh of uiliy from housing services, ϑ, is chosen o minimize he sum of squared disances beween model and daa for wo arges: he consrucion share of GDP (1.4) and gross household deb over annual GDP (8.). The share of consrained and unconsrained workers in he labor baskes are se o µ h = µ e = 1/. The scale parameers of convex invesmen adjusmen coss, Φ h and Φ k, are chosen such ha he fall in consrucion and equipmen capial invesmen in our baseline deleveraging scenario resembles heir behavior during he crisis. 5 The Calvo parameers are se o θ p = /3 and θ w = 3/4, such ha price and wages are adjused every 3 and 4 on average, respecively. This is consisen wih survey evidence for he Spanish economy (see e.g. Druan e al., 9). Finally, he parameers ha regulae he deb consrains are calibraed as follows. We se he household s iniial loan-o-value raio o m =.85, which is broadly consisen wih loan-o-value raios on new morgages in Spain prior o he crisis. The enrepreneurial iniial loan-o-value raio is chosen o mach he raio of gross non financial corporae deb o annual GDP (15.4 in 7), which yields m e =.71. The conracual amorizaion raes are se o 1 γ =. and 1 γ e =.4, such ha deb conracs have an average duraion of 5 for households and 5 for enrepreneurs, which is roughly consisenly wih Spanish experience 4 Using daa from BBVA Research, we obain ha he value of equipmen capial was 1.4 of he oal value of producive capial in 7. 5 In paricular, we se Φ h and Φ k such ha he accumulaed fall in consrucion and equipmen capial invesmen 8 afer he financial shock replicae heir accumulaed fall 8 afer heir peak in 7:Q4 (4.5 and 8 respecively). 18

19 prior o he crisis. Table 1 summarizes he calibraion. Table 1. Baseline calibraion Parameer Value Descripion Preferences β u.994 unconsrained household discoun facor β.98 consrained household discoun facor ϕ 4 (inverse) labor supply elasiciy ϑ.5 weigh on housing uiliy ε p 7 elasiciy of subs. across consumpion varieies ε w 3.31 elasiciy of subsiuion across labor varieies ω H.71 weigh home goods in consumpion baske ε H 1 elasiciy of impors wr erms of rade ε F 1 elasiciy of expors wr erms of rade ζ.78 scale parameer expor demand Technology α h.19 elasiciy oupu wr real esae α k.1 elasiciy oupu wr equipmen ω.66 elasiciy consrucion wr labor δ h.1 depreciaion real esae δ k.5 depreciaion equipmen µ e, µ h.5 share of consr. households in labor baskes Φ h 44 invesmen adjusmen coss consrucion Φ k 15 invesmen adjusmen coss equipmen Price/wage seing θ p.67 fracion of non-adjusing prices θ w.75 fracion of non-adjusing wages Deb consrains m.85 household LTV raio m e.71 enrepreneur LTV raio γ.98 amorizaion rae HH deb γ e.96 amorizaion rae HH deb 3 Adjusmen o a credi-crunch shock We model an economy undergoing a severe financial conracion ha reduces he availabiliy of credi for borrowers. In paricular, we consider as our baseline scenario 19

20 .85 LTV households (m).7 LTV enrepreneurs (m e ) Figure : Baseline deleveraging scenario: loan-o-value raios one consisen wih an unexpeced, gradual bu permanen drop in he loan-o-value raios of boh households and enrepreneurs, m and m e respecively. In paricular, we assume ha boh variables follow an AR(1) in differences, x = ρ x x 1 + ε x, x = m, m e, where we se ρ m = ρ me =.75 and where he long run fall is se o 1 percenage poins: ε m 1 = ε me 1 =.1 (1 ρ m ). The assumed pah for hese exogenous variables is displayed in Figure. We assume perfec foresigh in all our simulaions. As discussed in secion, our assumpion of long-run deb conracs gives rise o wo deb regimes. If collaeral values are above he conracual deb amorizaion pahs, hen ousanding deb (gross of new credi) is resriced by collaeral consrains, as in Kiyoaki and Moore (1997). Provided he laer consrains are binding, hen deb dynamics are deermined by he value of pledgeable collaeral: R 1 m E π +1 p h +1h for consrained households and R 1 m e E π +1 p h +1h e for enrepreneurs. If he opposie holds, hen new credi flows collapse o zero and ousanding deb simply follows he conracual amorizaion pah: γb 1 /π for households, and γ e b e 1/π for enrepreneurs. Figure 3 displays he response o he credi-crunch shock of boh deb limis, i.e. pledgeable collaeral values (dashed line) and conracual amorizaion pah (hin solid line), ogeher wih he acual equilibrium pah of ousanding deb (hick solid line), boh for enrepreneurs and households. Before he shock ( = ), he economy ress in he baseline regime, where deb levels equal pledgeable collaeral values. The credi crunch shock drives pledgeable collaeral values below he conracual amorizaion pahs already on impac ( = 1). Therefore, he economy swiches on impac

21 Enrepreneur deb 14 Household deb γ e b e 1 /π m e ph +1 π +1 he /R b e T* 1 1 γb 1 /π m p h +1 π +1 h /R b T** Figure 3: Baseline deleveraging scenario: deb dynamics o he alernaive regime in which enrepreneurial and household deb socks decay a raes 1 γ e π 1 and 1 γπ 1, respecively. In his phase, he economy undergoes a gradual and prolonged deleveraging process. Evenually, pledgeable collaeral values rise above he conracual amorizaion pah, a which poin borrowers are able o regain access o fresh funds. We denoe by T and T he ime a which he endogenous regime change akes place for enrepreneurs and households, respecively. Noice ha collaeral values and deb boh experience a surge a he ime of he regime change. This is because real esae becomes again valuable as collaeral, which pushes up borrowers demand for real esae, and hence is price. Thus, T and T also represen he duraion of he deleveraging process for enrepreneurs and households. In our baseline simulaion, deleveraging lass longer for households (T = 8, i.e. 7 years) han for enrepreneurs (T = 14, i.e. 3 and a half years), which, o a large exen, reflec he slower amorizaion raes assumed for he former (1 γ < 1 γ e ). The blue doed lines in Figure 4 show he economy s response o he deleveraging shock in our model wih long-erm deb. Toal consumpion declines all along he deleveraging process, and hen experiences successive recoveries a he imes when boh ypes of borrowers regain access o new loans (T = 14 and T = 8). The deleveraging shock has a sronger impac on oal invesmen, wih a maximum fall of 5.3 ha is reached 8 afer he shock, driven by lower expendiure in 1

22 boh real esae and equipmen capial. Consisenly wih wha is observed in many deleveraging episodes, invesmen recovers earlier han consumpion and before he deleveraging process is complee. In paricular, as Figure 4 reveals, invesmen picks up well before T, he ime when enrepreneur deb sars recovering. This iniial crediless recovery in invesmen before T is financed wih he increase in borrowers inernal saving. 6 Such a self-financed invesmen recovery is akin o he hose observed in some emerging and advanced economies in similar economic condiions (see e.g. Abiad, Dell Ariccia and Li, 11). The deflaionary process caused by he financial shock leads o a emporary depreciaion of he erms of rade, which fosers gross expors. On he oher hand, impors fall due o he combined effec of he erms-of-rade depreciaion and a severe conracion in domesic demand. Boh effecs give rise o a subsanial improvemen in ne expors during he deleveraging period. The posiive conribuion of he exernal secor, however, is no suffi cien o avoid a proraced recession ha lass for 1, wih a maximum GDP fall of 6.1 relaive o seady sae. This recession produces a significan reducion in employmen (6) despie he moderaion of real wages. The dynamic responses of mos variables in he scenario jus described are in sark conras wih hose ha would occur if all loans were o maure one period afer originaed, as i is cusomary in many macro models. To see his, he solid red lines in Figure 4 show he economy s response o he deleveraging shock in he case of one-period deb conracs (γ = ). In his case, he shock produces a sudden, much more drasic, and shorer-lived reducion in deb levels. This is because deb levels in ha scenario are only linked o collaeral values, which fall sharply on impac mosly as a resul of he drop in real esae prices. The laer acually fall by a similar amoun under long-erm deb conracs. However, in he laer case, he fac ha collaeral consrains cease o bind for a number of periods implies ha here is a emporary, bu prolonged, decoupling beween asse prices and deb levels. The sharp fall and faser recovery in deb levels under one-period deb carries over o oal consumpion, GDP and employmen. The impac fall in oal invesmen is similar, bu while i coninues falling gradually under long-erm deb, wih oneperiod deb i sars recovering righ afer he impac period (driven mosly by he faser recovery in real esae prices). Therefore, our assumpion of long erm deb produces in a naural way a scenario of prolonged recession caused by a slow process 6 In paricular, afer he impac period and prior o T enrepreneurs coninue o reduce heir consumpion, which in our framework may be inerpreed as dividend paymens, hus increasing heir reained earnings.

23 1 GDP 1 employmen household deb o annual GDP enrepreneurial deb o annual GDP long erm deb shor erm deb real esae prices pp oal invesmen 1 1 pp 1 5 annualized pp oal consumpion ex ane real ineres rae annualized pp CPI inflaion erms of rade real wage ne expors Figure 4: Baseline deleveraging scenario: long-erm vs shor-erm deb 3

24 of deb reducion, consisenly wih mos observed deleveraging episodes. 7 4 Srucural reforms Despie he fac ha financial crises evolve ino mosly demand-driven recessions, policy makers and academics have advocaed for alernaive ways o expand oupu and employmen, mos noably by reducing monopolisic disorions in labor and produc markes, wih he aim of unchaining posiive aggregae supply effecs. These srucural reforms are more srongly recommended for hose economies in which such disorions were larger during he upswing, as was he case in he periphery of he euro area. In his secion we invesigae he shor run and long run effecs of produc and labor marke reforms wihin he conex of our model and agains he background of he credi crunch described in he previous secion. Thus, he policy changes we model below occur as an immediae response o he financial shock. 4.1 Produc marke reform We firs implemen a measure aimed a srenghening compeiion in goods markes. In paricular, we consider an unexpeced, sudden and permanen reducion of 5 in he desired price markup, ε p / (ε p 1). The laer hus falls from 1.17 o The effecs of his reform (wih respec o he baseline, no-reform, scenario) are depiced in Figure 5. The main message from he figure is ha a produc marke reform reduces boh he severiy and he duraion of he recession caused by he deleveraging shock. Noice firs ha he reform has a posiive differenial effec on GDP in he long run, as one would expec, bu also in he shor and medium run. This shor/mediumrun improvemen is clearly driven by invesmen. By anicipaing he fuure long-run gains in economic aciviy, agens increase heir demand for invesmen goods already in he shor run. Boh consrucion and equipmen capial invesmen benefi from his effec. The shor/medium-run improvemen in invesmen is reinforced by an addiional channel, which hinges crucially on he endogenous change of deb regime ha akes place afer he deleveraging shock. As a resul of sronger consrucion demand, real esae prices fall by much less in he reform scenario. Real esae prices are a major 7 See, e.g., Garroe e al. (13) for an inernaional comparison of hisorical episodes of deleveraging. 4

25 5 GDP 5 employmen household deb o annual GDP enrepreneurial deb o annual GDP 14 baseline reform real esae prices pp oal invesmen 1 pp annualized pp oal consumpion ex ane real ineres rae annualized pp CPI inflaion erms of rade real wage ne expors Figure 5: The effecs of produc marke reform 5

26 driver of collaeral values, which consequenly fall less on impac. This leads collaeral values o cach up earlier wih borrowers conracual amorizaion pahs. In oher words, he reform brings forward he end of he deleveraging phase for enrepreneurs and households: we now have T = 1 and T = 1 respecively, versus T = 14 and T = 8 in he no-reform case. Ineresingly, an earlier recovery of he credi cycle implies ha real esae will be valued as effecive collaeral a an earlier dae, which pushes up is price oday. This las effec furher miigaes he fall in real esae prices (and, hence, in borrowers ne worh) on impac which self-reinforces an earlier recovery of credi flows. In addiion, since consumpion experiences a surge a he imes of he regime changes, agens also anicipae an earlier recovery in economic aciviy. This las effec feeds back ino higher invesmen demand oday, which in urn leads o higher real esae prices, higher collaeral values, and so on. 8 In sum, by anicipaing he end of he deleveraging phase, he reform unchains a firs-order posiive effec in he curren incenives of enrepreneurs o inves more oday, given ha he fuure ypical posiive effecs of he reforms will be fel earlier. In addiion, we noe ha neiher consumpion nor ne expors are much affeced in he shor run by he produc marke reform. In he case of consumpion, one reason is ha, while he deflaionary effec of he reform produces an addiional increase in real ineres raes and a rise in he real value of deb paymens, his is largely compensaed by he posiive income effec semming from he anicipaion of he long run income gains and by he lower fall in curren asse prices. Moreover, as we will see laer on, he negaive deb deflaion effec produced by srucural reforms urns ou o be subsanially weakened by he presence of long-erm deb. As regards ne expors, he increase in gross expors (due o he addiional depreciaion in he erms of rade) is essenially offse by he increase in he real (PPI-deflaed) value of impors (due o sronger domesic demand). Finally, noice ha he long-run gains in GDP do no carry over o employmen, due o he long-run increase in real wages. 4. Labor marke reform Analogously o he produc marke reform, we implemen an improvemen in labor marke compeiion by means of an unexpeced, sudden and permanen fall of 5 in desired wage markups, ε w / (ε w 1). In his case, desired markups fall from 1.43 o This simulaion proxies for a labor marke reform ha affecs unions bargaining power. The effecs of his reform are depiced in Figure 6. 8 In he case of enrepreneurs, he higher invesmen demand (relaive o he baseline scenario) is parially financed by a fall in heir consumpion, which as menioned before may be inerpreed as a cu in dividend paymens. 6

27 5 GDP 5 employmen household deb o annual GDP enrepreneurial deb o annual GDP 14 baseline reform real esae prices pp oal invesmen 1 pp annualized pp oal consumpion ex ane real ineres rae annualized pp CPI inflaion 4 6 erms of rade real wage ne expors Figure 6: The effecs of labor marke reform 7

28 The effecs on GDP are qualiaively similar o hose of a produc marke reform, alhough he iming is differen. In his case, he impac effec is very essenially nil, bu he reform gahers momenum over ime, soon afer is implemenaion, and evenually generaes a long run posiive effec idenical o ha of he produc marke reform ha, in his case, exends also o employmen. This las effec conrass wih he case of he produc marke reform, which feaured sizable shor-run employmen gains bu no long-run effec. This difference sems from he fac ha real wages now experience a long-run decline, a logical consequence of he permanen increase in he labor marke compeiion. Unlike in he case of a produc marke reform, he labor marke reform does no have a noiceable effec on invesmen or on he duraion of he deleveraging process. The reason is ha he permanen reducion in real wages shifs relaive facor demand owards labor and away from capial, which offses he posiive effec on invesmen from he anicipaion of long-run gains in economic aciviy described earlier, in he conex of he produc marke reform. The absence of an improvemen in he demand for invesmen goods carries over o asses prices and hence o collaeral values, which explains why he daes of he regime changes are no affeced by his reform. Ne expors are no much affeced eiher: he addiional erms of rade depreciaion is largely offse by he improvemen in domesic demand. Insead, he gradual improvemen in GDP relaive o he baseline scenario is driven mosly by consumpion. On he one hand, Ricardian (unconsrained) households benefi from he fac ha he labor marke reform produces a raher weak deflaionary effec, and hence a small increase in real ineres raes. Indeed, he double layer of nominal rigidiies (wages and prices) implies ha an increase in desired wage markups akes much longer o affec producion prices han an increase in desired price markups. This makes i easier for he posiive income effec semming from he anicipaion of long run gains o become he dominan force in he consumpion of Ricardian households. On he oher hand, consrained households wage income increases gradually as imes go by, as he increase in employmen gradually overcomes he decline in real wages. Finally,as enrepreneurs do no fronload invesmen, heir consumpion is significanly higher han in he produc marke reform scenario Increased wage flexibiliy In he previous secion we considered a reducion in desired wage markups, analogous o and hence comparable wih he produc marke reform analyzed in secion 4.1. However, labor marke reforms ypically affec no only desired markups over reser- 8