International Capital Flows and the Boom-Bust Cycle in Spain (*)

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1 Inernaonal Capal Flows and he oom-us Cycle n Span (*) Jan n' Veld (DG-ECFIN, EU Commsson), Rober Kollmann (ECARES-UL and CER), earce aaraccha (JRC, EU Commsson), arco Rao (JRC, EU Commsson), Werner Roeger (DG-ECFIN, EU Commsson) We sudy he on dynamcs of foregn capal flows and real acvy durng he recen boombus cycle of he Spansh economy, usng a wo-counry New Keynesan DSGE model. We esmae he model usng daa for Span and for an aggregae of he res of he world (ROW). The model ncludes a consrucon secor and a governmen. We show ha fallng rsk prema on Spansh housng, as well as a he fall n he neres rae spread beween Span and he ROW fuelled he sharp rse n Spansh housng nvesmen before he fnancal crss, and ha hese drvers ncreased he fragly of he balance shees of Spansh households and frms. We fnd no srong evdence ha excessve wage growh maered for exernal mbalance durng he boom. In he afermah of he global fnancal crss, fallng house prces, a resurgence of he Spansh exernal neres spread, and a ghenng of collaeral consrans for Spansh households and frms, led o a sharp reducon n capal flows o Span, and o a perssen fall n Spansh real acvy. The correcon of he Spansh rade defc, snce he crss, reles mosly on a declne n domesc absorpon rggered by ghened of fnancal consrans. JEL code: C, E2, E32, E62 Keywords: nernaonal capal flows, boom-bus cycle, sudden sop, rebalancng, housng marke, fnancal frcons, Span, European oneary Unon. (*) We hank assmlano san for useful dscussons. Helpful suggesons were also receved from parcpans a he December conference Curren Accoun Imbalances and Inernaonal Fnancal Inegraon held a he European Commsson (russels). The vews n hs paper are hose of he auhors and should no be arbued o he European Commsson. Correspondng auhor: Rober Kollmann, ECARES, C 4, Unversé Lbre de ruxelles, -050 russels, elgum. E-mal addresses: an.nveld@ec.europa.eu, rober_kollmann@yahoo.com, bearce.paaraccha@rc.ec.europa.eu, marco.rao@rc.ec.europa.eu, werner.roeger@ec.europa.eu

2 . Inroducon Afer he creaon of he Euro n 999, Greece, Ireland, orugal, Span, and oher counres n he EU perphery ran szable curren accoun defcs. Ths was ofen accompaned by oupu and consrucon booms n hese counres, and by nflaon raes above he Euro Area average. In he wake of he global fnancal crss ( ), prvae capal flows o he perphery counres fell sharply, and a srong conracon n real acvy and house prces ensued. Ths paper provdes a quanave analyss of he on dynamcs of exernal capal flows and real acvy n Span, he larges of he Euro Area counres ha receved szable capal nflows afer he creaon of he Euro, and hen experenced a sudden sop. We do so usng a wo-counry New Keynesan Dynamc Sochasc General Equlbrum (DSGE) model conssng of Span and an aggregae of he res of he world (ROW). We esmae hs model usng quarerly daa, for Span and he ROW durng he perod 995Q-203Q2. The Spansh bloc of he model has a rch srucure ha allows us o capure he key feaures of he Spansh boom-bus cycle. In parcular, we assume a consrucon secor and a governmen secor; Spansh households and non-fnancal frms face collaeral consrans. The model assumes demand and supply shocks n goods, labor and asse markes, as well as nomnal prce and wage rgdes. We use he model as a laboraory for quanfyng he key drvers and ransmsson mechansms ha explan he dynamcs of he Spansh rade balance snce 995. The creaon of he Euro elmnaed nra Euro Area currency rsk and led o a convergence of Spansh neres raes o he lower neres raes n he res of he Euro Area. Compeng explanaons for he boom n he Spansh economy are loosenng cred condons and housng and sock marke bubbles. We fnd ha all hese facors fuelled a sharp rse n Spansh housng nvesmen and house prces, and ncreased he fragly of he balance shees of Spansh households and non-fnancal frms. Our esmaes sugges ha a large par of he buld-up n Spansh ne exernal deb afer he nroducon of he Euro can be arbued o posve shocks o foregn capal nflows. In he afermah of he global fnancal crss, a fall n house prces, a resurgence of he Spansh exernal neres rae spread, and a ghenng of collaeral consrans for households and frms, led o a sharp reducon n capal flows o Span, and a perssen fall n Spansh oupu and housng nvesmen. The fall n prvae See Kyoak and oore (997), Iacovello (2005), Iacovello and Ner (2008), Kollmann, Roeger and n Veld (202), Kollmann, Rao, Roeger and n Veld (203) and Kollmann (203). 2

3 capal nflows was a frs parly counerbalanced by a rse n publc capal nflows; however, publc capal nflows oo dred up when he Spansh soveregn deb crss eruped, n 200, followng he dramac deeroraon of he Spansh governmen balance due o he recesson. Our analyss hghlghs he key role of he housng marke for he ransmsson of exernal capal supply shocks o Spansh real acvy. Real house prces doubled beween 200 and 2007, and hen fell by abou 40% (2008-2). Ths rggered a severe fnancal crss, whch led o a sharp conracon of lendng o frms and households, and a rse n loan raes. The economc evens n Span (and oher European perphery counres) durng he pas 5 years are, n many respecs, remnscen of he boom-bus cycles accompaned by capal nflows and sudden sops experenced by many economes n Lan Amerca and Asa durng he 20 h cenury; see Calvo e al. (2004) for an emprcal overvew. The leraure on sudden sops uses hghly sylzed models; see, e.g., Calvo (998), endoza (200), Res (203) and Fornaro (203). y conras, he presen paper analyzes a boom-bus cycle lnked o nernaonal capal n- and ouflows, usng a fully-fledged esmaed DSGE model. Economc heory suggess ha a counry s CA reflecs domesc and foregn macroeconomc and fnancal shocks, and he srucural feaures of he domesc and foregn economes. Ths underscores he mporance of analyzng he CA usng a quanave dynamc general equlbrum model ha capures he relevan shocks, and her ransmsson o he macroeconomy. Several recen emprcal sudes have hghlghed he role of housng and cred markes for he dynamcs of he curren accoun (e.g., Azenman and Jnarak (203), Chnn e al. (203), European Commsson (202)). The paper here analyzes ha role usng an esmaed DSGE model. The presen paper s also relaed o a leraure ha analyzes curren accoun dynamcs usng DSGE models (e.g., Kollmann (998), Erceg e al. (2006), Gomes, Jacquno and san (202)); by conras o he paper here, ha leraure has ypcally used calbraed models (no esmaed), and has absraced from housng markes and he key fnancal frcons consdered n he presen model. Secon 2 descrbes he dynamcs of he Spansh macroeconomy durng he pas wo decades. Secon 3 descrbes our model. Secon 4 dscusses model esmaes. Secon 5 dscusses 3

4 dynamc responses o shocks n he esmaed model, and Secon 6 dscusses hsorcal shock decomposons. Secon 7 concludes. 2. Dynamcs of he Spansh macroeconomy For mos of he decade up o 2007, GD growh n Span exceeded average growh n he Euro Area. u he fnancal and economc crss h Span severely, wh quarer-o-quarer annualzed growh raes fallng o almos -6% n he frs quarer of 2009; Span experenced a weaker recovery n 200- han he res of he Euro Area, and enered no a second-dp recesson n 202. Durng he boom years, all domesc demand componens grew faser han GD; hs was especally he case for nvesmen, and n parcular resdenal nvesmen (see Fg..e). y conras he Spansh consumpon-o-gd rao rose much less; ha rao averaged abou 60% before he crss (abou 4 pp. hgher han he Euro Area average), bu fell o 57.5% by 203 (see Fgure.b). The srong performance of nvesmen (especally n he consrucon secor) relave o oupu n he 2000s, coupled wh a subsanal ncrease n house prce n hs perod s suggesve of a housng bubble ha developed n Span pror o he crss. I s noceable ha house prces n real erms have shown some correcon snce her peak n 2007, bu had by 202 only fallen back a her 2003 levels. ror o he launch of he Euro (..999), Spansh nomnal neres raes had been markedly hgher han neres raes n he res of he Euro Area. The creaon of he Euro led o a rapd convergence of Spansh nomnal raes o Euro Area raes. Tha reducon n nomnal neres raes led o a sharp reducon n Spansh real neres raes, as Span experenced hgher nflaon han he res of he Euro Area, unl he fnancal crss, due o a srong expanson of aggregae demand. In fac, Spansh real neres raes were even negave beween 200 and Real neres raes rose o posve values n he mmedae afermah of he fnancal crss, bu were back o values near zero n recen years. The boom n domesc demand was accompaned by a srong deeroraon n he rade balance. Afer he second half of he 990s he Spansh economy moved from small rade surpluses o a very large rade defc of more han 7% of GD by 2007, and o even larger curren accoun defcs. The perssen rade defcs led o a srong rse n Span s ne foregn deb (from around 20% of GD n he lae 990s o more han 90% of GD by 2009). Snce he crss he Spansh rade defc has shrunk consderably, o close o balance by he end of 20, bu Span s ne nernaonal nvesmen poson remans around -90% of GD. efore he crss, Span s publc fnances were n beer healh han he Euro Area average. Spansh governmen balances mproved 4

5 markedly beween he md-990s and he md-2000s, a governmen budge surplus was even recorded beween 2005 and uch of hs fscal mprovemen was no due o ncreases n ax revenues assocaed wh changes n he composon of GD, n parcular ransory asse boom revenues (arnez-ongay e al., 2007). The crss led o publc defcs peakng a % of GD n 2009, and have remaned subsanal snce hen. Tha deeroraon n he fscal poson reversed he rend declne n gross deb, whch had fallen o 36% of GD n 2007; publc deb ncreased rapdly o close o 90% of GD by he end of 202. The deb of he (non-fnancal) busness secor has also rsen sharply before he crss. The ousandng sock of loans o non-fnancal corporaons as % of GD doubled beween 2003 and 2009, from 45 o 90% of GD, and hen fell o 60% of GD. 3. odel descrpon [INCOLETE!] We consder a wo-counry model conssng of Span and he res of he world (ROW). 2 [In on-gong work, we exend he seng o a hree-counry world conssng of Span, he res of he Euro Area, and he res of he world.] Span produces radable goods whch are mperfec subsues o goods produced n he ROW. Households engage n nernaonal fnancal markes and here s near perfec nernaonal capal mobly. There are hree producon secors, a fnal goods producon secor as well as nvesmen goods producng secor and a consrucon secor. We dsngush beween Rcardan households whch have full access o fnancal markes, and cred consraned households facng a collaeral consran on her borrowng. The economy s par of a moneary unon and faces an exogenous neres rae. There s a fscal auhory, whch follows rules based sablzaon polces. ehavoral and echnologcal relaonshps can be subec o auocorrelaed shocks denoed by k U, where k sands for he ype of shock. The logarhm of k U wll generally be auocorrelaed wh k k auocorrelaon coeffcen and nnovaon Frms 3... Fnal goods producers Frms n he fnal goods producon secor are ndexed by. Each frm produces a varey of he domesc good whch s an mperfec subsue for varees produced by oher frms. 2 The model s an exenson of he QUEST model esmaed on euro area daa (Rao, Roeger and n ' Veld, 2009) wh a housng secor and collaeral consraned households. A smlar verson has been esmaed on US daa (n ' Veld e al., 20) and on German daa (Kollmann, Rao, Roeger, n Veld and Vogel, 203). 3 Y Lower cases denoe logarhms,.e. z = log(z ). Lower cases are also used for raos and raes. In parcular we defne p / as he relave prce of good w. r.. he GD deflaor 5

6 ecause of mperfec subsuably, frms are monopolscally compeve n he goods marke and face a demand funcon for goods. Domesc fnal good producers sell goods and servces o domesc and foregn households, nvesmen and consrucon frms and governmens. Oupu s produced wh a Cobb Douglas producon funcon usng capal K, () and producon workers Y ) L L as npus Y ( UCA K U, wh Toal employmen of he frm L, L d. 0 L s self a CES aggregae of labour suppled by ndvdual households. The parameer deermnes he degree of subsuably among dfferen ypes of labour. Frms also decde abou he degree of capacy ulzaon ( UCA ). There s an economy wde echnology shock Y U followng a random walk process plus drf. We also consder fnancal shocks n he producon process: all frms pay facors of producon before producon occurs. Frms face he followng collaeral requremen: (2.a) ( ) ( ) ( ), where s frm deb a he end of perod, whle s he perod real neres rae on loans. The loan-o-value rao, (2.b) The perod dvdend of a fnal good producers s: (2.c) where dv ( ad p Y ( ) ad NF L ( r ( L ) ad ) UCA, s subec o exogenous dsurbances: NF w L ( UCA K p ) ad K, dv K ( dv K denoes he renal rae of capal. Frms face echnologcal and regulaory consrans whch resrc her prce seng, employmen and capacy ulzaon decsons. rce seng rgdes can be he resul of he nernal organzaon of he frm or specfc cusomer-frm relaonshps. Coss of adusng labour have a ob specfc componen (e.g. ranng coss) bu hgher employmen adusmen coss may also arse n heavly regulaed labour markes wh search frcons. Coss assocaed wh he ulzaon of capal can resul from hgher manenance coss assocaed wh a more nensve use of a pece of capal equpmen. Fnally, we follow Jermann and Quadrn (202) and assume ha he frm s payou s subec o a quadrac cos. The followng convex funconal forms are chosen )) 6

7 (3) ad dv L ad ( L ) w ( L u ad ad ( UCA ) 2 ( ucap L ) p L L 2 I dv 2 dv dv 2 Y K ( 2 ucap, ) ( ucap ) 2 ucap,2 ( ucap ) 2 ) where dv s a dvdend arge. The frm deermnes labour npu, capal servces, he demand for loans, dvdends and prces opmally n each perod gven he echnologcal and admnsrave consrans as well as demand and fnancng condons. Denong wh V he marke value of frm a dae, we have: V ax dv E V s.. (), (2a) and (2c),, where, s he neremporal margnal rae of subsuon of he Rcardan household (see below) Resdenal consrucon onopolscally compeve frms h n he resdenal consrucon secor use new land Consr ( J ) sold by (Rcardan) households and fnal goods ( J ) o produce new houses usng Land a CES echnology (4) J H s L L J L ( L) ( ) L L Land L Consr L ( s ) L L J Subec o a quadrac adusmen cos consran (5) ad H ( H ) 2 H H 2 Y New and exsng houses are perfec subsues. Thus households can make capal gans or suffer capal losses dependng on house prce flucuaons Invesmen goods producers There s a perfecly compeve nvesmen goods producon secor whch combnes domesc and foregn fnal goods, usng he same CES aggregaors as households and governmens do o produce nvesmen goods for he domesc economy. Denoe he CES 7

8 aggregae of domesc and foregn npus used by he nvesmen goods secor wh np J, hen real oupu of he nvesmen goods secor s produced by he followng lnear producon funcon, (6) J J np U I whereu s a echnology shock o he nvesmen good producon echnology whch self I follows a random walk 4 (7) u I I u UI 3.2. Households The household secor consss of a connuum of households h 0,. A fracon r s of all households are Rcardan and ndexed by r and c s households are cred consraned and ndexed by c. The perod uly funcon s dencal for each household ype and specfed as a nesed consan elascy of subsuon (CES) aggregae of consumpon ( C ) and housng h h servces ( H ) and separable n lesure ( L ). We also allow for hab perssence n consumpon. Thus perod uly funcon s:, L ) logs H H H (8) h h h H h h H h L h U ( C, H C C hc H s H H H H exp( u ) L All wo ypes of households supply dfferenaed labour servces o unons whch maxmze a on uly funcon for each ype of labour. I s assumed ha ypes of labour are dsrbued equally over he wo household ypes. Nomnal rgdy n wage seng s nroduced by assumng ha he household faces adusmen coss for changng wages. These adusmen coss are borne by he household. h 3.2. Rcardan households Rcardan households have full access o fnancal markes. They hold domesc governmen r F, r bonds( ) and bonds ssued by oher domesc and foregn households (, ), real G r capals ( K ) used n he fnal goods producon secor as well as he sock of land ( Land ) r whch s sll avalable for buldng new houses. In addon hey provde loans o nonfnancal frms ( NF ) and hey hold a sock of deposs ( ) wh a fnancal nermedary who provdes loans o cred consraned households and o non-fnancal frms. The household 4 Ths shock s nroduced o capure dvergen rend n relave nvesmen prces. 8

9 receves ncome from labour, fnancal asses, renal ncome from lendng capal o frms, sellng land o he resdenal consrucon secor plus prof ncome from frms owned by he household (fnal goods r, resdenal consrucon r and fnancal nermedares r ). We assume ha all domesc frms are owned by Rcardan households. Income from labour s axed a rae w, consumpon a rae c. In addon households pay lump-sum axes T LS. We assume ha ncome from fnancal wealh s subec o dfferen ypes of rsk. Domesc bonds and neres ncome from deposs yeld rsk-free real reurn equal o r. Domesc and foregn bonds are subec o (sochasc) rsk prema lnked o ne foregn ndebedness. An equy premum on real asses arses because of uncerany abou he fuure value of real asses. Furhermore, he Rcardan household s subecve dscoun facor s subec o random shocks. The household s decson problem s o maxmze lve-me uly V U C L H E V (where, s he agen s subecve dscoun facor r r r r r r (,, ), beween perods and +) subec o he followng budge consran and laws of moon of asse socks: ( ) p C p I p ( ) I ( D ) rer c C r I r H c H, G, r NF F, ( r )( D ) ( r ) rer (( ) ) p K G, r r NF F F, r K K K K I r, ( W ) r W ( ) L Land r H r LS r w L ad W p J dv T ; K J ( ) K ; r r K r H J ( ) H ; r H, r H H, r Land ( g ) Land J. L Land The nvesmen decsons w.r.. physcal capal and housng are subec o convex adusmen r H, r coss, herefore we make a dsncon beween real nvesmen expendure ( I, I ) and r H, r physcal nvesmen ( J, J ). Invesmen expendure ncludng adusmen coss s gven by H (0a) I r J r K 2 J K r r I 2 ( J r ) 2 (0b) I H, r J H, r H 2 J H H, r r 2 H I ( J H, r The budge consran s wren n real erms wh all prces expressed relave o he GD deflaor (). Invesmen s a compose of domesc and foregn goods. ) 2 9

10 We follow ernanke and Gerler (999) and assume ha resdenal and non-resdenal nvesmen decsons are subec o non-fundamenal shocks. Specfcally, he Euler equaons for resdenal and non-resdenal nvesmen are dsurbed by exogenous shocks K z and respecvely ha can be nerpreed as represenng expecaonal bases regardng fuure nvesmen reurns: ( z ) E { Q ( ) ( ) }/ Q, K r, K K K K K K r, K, ( z ) E { U Q ( )}/ Q. H r r, H H r, H, H, Lke ernanke and Gerler, we use he erm "bubble" loosely o denoe emporary devaons of asse prces from fundamenals due o waves of opmsm and excessve rsk akng n perods of rsng asse prces, and waves of pessmsm or pancs n perods of ncreased uncerany. In he conex of he curren crss, alernave explanaons could be gven for a sudden fall n asse prces. For example, an ncrease n H z, z could capure wha Goron (200) calls a "panc", o descrbe he uncerany abou he value of ceran asse classes whch have forced banks o delver and dump asses, leadng o fallng asse values. A rsng z could also capure wha Hall (200) refers o as "prncpal agen frcons", whch he models by nroducng an exogenous wedge shock beween safe (governmen bonds) and rsky asses (equy and houses) n order o emprcally mach rsng spreads beween safe and rsky asses. The neres rae ha households face when makng consumpon and nvesmen decsons F, r depends on he aggregae level of foregn ndebedness (defned as ( ) /( p Y ) ) (3) h ( rprem Y F ) Ths specfcaon corresponds o he deb-dependen neres rae premum wdely assumed n open economy models (e.g., Senhad (994), Kollmann (2002), Schm-Grohé and Urbe (2003)). Ths specfcaon nduces a saonary equlbrum. However, we also regard he neres elascy w.r.. foregn deb as an mporan behavoral parameer descrbng he rsk olerance of foregn credors. The parameer rprem ogeher wh he rae of me preference of Rcardan households deermnes he seady sae deb level of he economy Cred consraned households Cred consraned households dffer from Rcardan households n wo respecs. Frs hey c r have a hgher rae of me preference (,, ) and hey face a collaeral consran on 0

11 her borrowng. They borrow c exclusvely from domesc Rcardan households. The lfe- c c c c c c me uly of Rcardan households s gven by V U( C, L, H ) E, V. Rcardan households maxmze lfe-me uly subec o he followng consrans: ( ) p C p ( ) I ( r ) ) ( ) w L ad ( W ) T ; c C c H H H, c c c W c W LS, c c H, c H c H J ( ) H ; ( r ) c c ( ) c ( c ) c H c r p H. There s a non-fundamenal shock o housng nvesmen whch s consraned o be equal across household ypes Wage seng A rade unon ses he (afer-ax) real wage rae a a mark-up above he rao of a weghed average of he margnal ules of lesure of he wo household ypes o a weghed average of her margnal ules of consumpon, mulpled by a me-varyng wage mark-up facor, ha reflecs wage adusmen coss (5) ad W ( W W ) 2 sfw sfw W W 2 Y The wage rule s obaned by equang a weghed average of he margnal uly of lesure o a weghed average of he margnal uly of consumpon mes he real wage of hese wo household ypes, mulpled by a me-varyng wage mark-up facor: (6) s U s U W c c r r W L, L, W ( ) c c r r C C s Uc, s Uc, ( ) where W s he wage mark-up facor (ha facor flucuaes around he nverse of he elascy of subsuon beween dfferen varees of labour servces). 3.3 Trade and he curren accoun In order o faclae aggregaon we assume ha households, he governmen and he frm secor have dencal preferences across goods used for prvae consumpon, publc expendure and nvesmen. Le G, G, Z C, I, C, I be demand of an ndvdual household, nvesor or he governmen, and hen her preferences are gven by he followng uly funcon

12 2 (7) ) ( ) ( ) ( f d Z u s Z u s Z where he share parameer s can be subec o random shocks u and d Z and f Z are ndexes of demand across he connuum of dfferenaed goods produced respecvely n he domesc economy and abroad. Exporers buy fnal domesc goods X and ransform hem no exporables usng a lnear echnology. Exporers ac as monopolsc compeors n expor markes and charge a markup over domesc prces. Thus expor prces are gven by (8) X X Imporers buy foregn goods a quany from foregn exporers and sell hem on he domesc marke. Imporers are monopolsc compeors on he marke for mpored goods and charge a mark over he purchase prce of mpors denomnaed n domesc currency. (9) F E ark-up flucuaons arse because of prce adusmen coss. Expors and mpors ogeher wh neres receps/paymens, and he exogenous balance of prmary ncomes and ransfers deermne he evoluon of ne foregn asses denomnaed n domesc currency. (20) F X F F F X ) ( 3.4 olcy oh governmen expendure and receps respond o busness cycle condons. On he expendure sde we denfy he sysemac response of governmen consumpon, governmen ransfers and governmen nvesmen o he annual GD growh rae. In addon, all hree expendure componens are used o sablze he deb o GD rao, where T b s he governmen deb arge and T def s he assocaed defc arge. For governmen consumpon and governmen nvesmen we specfy he followng rules for governmen consumpon and nvesmen, normalzed by rend producvy, G c and G : (2) CG T CGDEF T CG CG G G CG Lag G G u def Y b Y y y c c c c 4 ) 4 ( ) (

13 3 (22) IG T IGDEF T IG IG G G IG Lag G G u def Y b Y y y 4 ) 4 ( ) ( Governmen consumpon and governmen nvesmen can emporarly devae from her long run arges G c and G n response o flucuaons n growh raes. In addon, governmen expendure s used for sablsng he deb o GD rao, where T b s he governmen deb arge and T def s he assocaed defc arge. The shocks u CG and u IG are whe nose. The ransfer sysem consss of wo pars, unemploymen benefs UEN and oher ransfers TR. The former provdes ncome for he unemployed ) ( NART W L O O. Oher ransfers TR consss of ransfers o pensoners O and oher ransfer paymens, and s used for sablsng he deb o GD rao. We assume ha unemploymen benefs and pensons are ndexed o wages wh replacemen raes U b and R b respecvely. (23) TR T TRDEF T TR R NART W U u def Y b Y w O b L O O w b r ) ( where u TR s an auocorrelaed shock. Governmen revenues G R conss of axes on consumpon as well as capal and labour ncome. (24) ] [ I K H H c c c w G K )- (Y -W L I C L W ssc R We assume consumpon and capal ncome ax o follow a lnear scheme, bu a progressve labour ncome ax schedule (25a) w w w Y 0 where w 0 measures he average ax rae, and w he degree of progressvy. A smple frsorder Taylor expanson around a seady sae growh rae yelds (25b) w w w w y y ) 4 ( Governmen deb ( ) evolves accordng o (26) LS G G C G C T R TR I C ) (. where s he mplc neres rae he governmen pays on s deb, whch depends on he average maury srucure of soveregn deb ( ) ( ) and he polcy rae augmened by a

14 mark-up made up of a soveregn rsk premum, whch s assumed o depend on he governmen deb-o-gd rao and an auoregressve erm. rpb (26') ( ) mup rprem ( / Y / Y) oneary polcy s modeled exogenous, wh neres raes EA se by he EC. (27) EA u RRE In he years pror o EU, he dfferenal beween he polcy rae n Span and he (synhec) EA-average was gradually elmnaed. Fnally, we defne a moneary polcy as he devaon of EA from a synhec neres rae deermned by a Taylor rule for Span ha responds o consumer prce nflaon and he annual growh rae of oupu, wh weghs based on esmaes for he euro area (Rao e al., 2009) (28) z EA EA lag ( lag)[ r y ( gy gy EQ T gy C T ( ) 2 gy 3 4gy) / 4] 3.5 arke clearng for fnal goods and domesc cred marke clearng condons hold for fnal domesc goods and for and fnal mpored goods requres: d G d (29) np, d Consr G, d, Y C J J C I X, (30) C J C I, f np, f G, f G, f where oal domesc and mpored consumpon C s he sum of savers and borrowers consumpon, wh her per-capa consumpon mulpled by he respecve populaon shares (3a) r s and C c s : r r, c c, s C s C,wh d, f Smlarly, oal housng nvesmen s defned as (3b) J H s r J H, r s c J H, c and equlbrum n he labour marke requres (3c) r r c c r c L s L s L wh L L. Cred consraned households only engage n deb conracs wh Rcardan households,.e. r c s r (32) c. s 4

15 4. odel esmaon [INCOLETE!] We calbrae seleced parameers ha pn down key seady sae properes of he model, and esmae he remanng parameers usng ayesan mehods. The esmaon uses quarerly daa for he perod 995Q o 203Q2. 5 Concernng he seady sae calbraon, parameers shown n Table have been calbraed o mach raos of man economc aggregaes (producve nvesmen, consrucon nvesmen and governmen consumpon and nvesmen) o GD over he perod The wo general excepons o hs are he calbraon of he labour marke and he seady sae deb raos. For he former he averages can no longer be consdered represenave of he Spansh labour marke, as labour marke reforms have led o a regme shf n he Spansh economy. Insead we base he calbraon of labour marke parameers on he full sample 995Q-203Q2. The seady sae employmen rae as share of oal populaon s se o 0.4, he wage share o 57%. Concernng he governmen deb rao, we mpose he deb arge of 60% of GD, whch s close o he sample average. Ths arge mples, gven he nomnal growh rae n he seady sae, a defc arge of 2.5% of GD. The average maury of soveregn deb s se a 5 years. Tax raes are calbraed on sample averages. Governmen ransfers o households are se o 5% of GD, benef ndexaon (b U ) s esmaed and penson ndexaon (b R ) s se o mach hs seady sae calbraon. For consrucon of he moneary polcy shock, Taylor rule coeffcens are mposed based on esmaes for he euro area (Rao e al., 2009). The consan n he mark-up of soveregn bond neres raes ( mup ) s se a 0.4% quarerly. ased on he whole sample, he quarerly GD rend growh rae was se o 0.55%, whle he nflaon rend growh rae s se o 0.5%. Cred-consraned households are calbraed wh a hgh rae of me preference, 4% per quarer, whle he dscoun rae for non-consraned households s esmaed (see below). The euro area dscoun rae s se a 0.5% quarerly, openness s esmaed a The esmaon resuls of he man srucural parameers are summarsed n Table 2. 7 The populaon share of Rcardan households s r s esmaed a 0.59, mplyng he share of cred- 5 We use he DYNARE oolbox for ATLA (Ademan e al., 20) o conduc he frs-order approxmaon of he model, o he calbraed seady sae and o perform he esmaon. Resuls presened here are based on poseror mode esmaon. Full eropols runs are n progress. A dealed descrpon of daa sources and esmaon s descrbed n an appendx. 6 Ths perod was chosen o exclude he more urbulen 2000s, n whch several varables (for example consrucon nvesmen share n GD) could have dverged from her hsorcal level. 7 HDnf and HDsup denoe he bounds of he 90% Hghes robably Densy nerval. The pror dsrbuons used and poseror esmaes of all parameers can be found n he supplemenary appendx. 5

16 consraned households s c of 0.4. Concernng consumpon, he neremporal elascy of subsuon s se o one, hab perssence h s esmaed o be 0.75, and he subsuon elascy for housng servces H s esmaed a 0.7. The seady sae dscoun facor for Spansh households β r s esmaed close o 0.992, reflecng a hgher propensy o consume han for he res of he euro area. The esmae for rprem mples an nelasc neres rae w.r. exernal ndebedness (he exernal borrowng rae rses by 3 bass pons for every 0 percenage pons ncrease n ne foregn lables normalzed by domesc GD). Ths low esmae or rprem reflecs he perssen buld-up n ne foregn lables snce he launch of he Euro was only accompaned by modes changes n he neres raes spread beween Span and he res of he Euro Area. Fscal polcy reacons are generally couner cyclcal, whle governmen consumpon also conans a deb- and defc sablsng response. The esmaed elascy of he soveregn rsk premum w.r.. he governmen deb-o-gd rao mples an ncrease n he rsk premum of 2 bps. for a 0 pp. ncrease n he deb rao. All model properes dscussed n wha follows are evaluaed a poseror esmaed of he model parameers. One perod n he model represens one quarer n calendar me. 5. Impulse response funcons In hs secon, we dscuss he dynamc effecs of shocks whch have played a promnen role for he boom and bus cycle of he Spansh economy. In parcular we look a fnancal shocks and rade shocks. Shock o housng rsk premum (house prce bubble), Fgure 2.a. A rse n he house prce drven by a fall n he housng rsk premum (posve housng bubble) ncreases resdenal nvesmen. Whle he shock leads households o shf expendure from consumpon o resdenal nvesmen, he shock booss aggregae demand, whch rases domesc nflaon; nally, hs reduces he domesc real neres rae (gven he weak response of he nomnal neres rae, due o moneary unon), whch also smulaes non-housng nvesmen. The rse n domesc absorpon rases domesc GD and employmen. The rade balance deeroraes perssenly--hs s also due o he loss of exernal compeveness ha resuls from hgher domesc nflaon. The rse n nflaon also leads o a real apprecaon (fall n he real exchange rae, n Fgure 2.a). 6

17 Shock o household loan o value rao, Fgure 2.b. A loosenng of household fnancng condons allows cred consraned households o ncrease boh consumpon and resdenal nvesmen, bu crowds ou non-resdenal nvesmen. Absorpon ncreases, whch leads o a rade balance deeroraon. Exernal rsk premum shock, Fgure 2.c. A permanen reducon of he exernal rsk premum leads o a perssen ncrease of all domesc demand componens. The expansonary effec s renforced n he shor run by he fall n he real neres rae caused by nflaonary pressure. ecause of a loss of prce compeveness and rsng domesc demand he rade balance urns srongly negave. I s however, mporan o noce ha, even hough here s a permanen reducon of he rsk premum, he effec on domesc demand s no permanen. Ths s bes llusraed n he case of resdenal nvesmen. The fall n he rsk premum lowers morgage raes, however because of a (land) consran for he supply of houses hs leads o an ncrease n house prces, whch evenually domnaes he capal cos effec and revers he resdenal nvesmen boom. Neverheless he demand expanson remans mporan over he medum erm and leaves he rade balance perssenly negave. Shock o frm loan-o-value rao (fnal goods secor), Fgure 2.d. A ghenng of frm fnancng condons leads o a emporary reducon of producve nvesmen, whch s only margnally offse by a rse n prvae consumpon and resdenal nvesmen. Ths ranslaes no an mprovemen n he rade balance (whch s however small compared o he drop n producve nvesmen). Shock o rsk premum on producve capal, Fgure 2.e. Effecs are very smlar o changes n frm fnancng condons. Shock o governmen consumpon, Fgure 2.f. An ncrease n governmen consumpon crowds ou prvae demand componens, mos noably producve nvesmen. However he ne demand effec remans posve, whch leads o an nal declne of he rade balance. 7

18 Shock o expor demand, Fgure 2.g. Fgure 2.g shows dynamc responses o a shf of preferences n favor of Spansh goods. Tha expor demand shock leads o a perssen ncrease n domesc GD. The resulng rse n domesc nflaon leads o a declne n he Spansh real neres rae, and hus he rse n expors does no crowd ou domesc demand. The shock only leads o a shor run rade balance mprovemen, because of opposng ncome and compeveness effecs. Spansh expor prce mark-up shock, Fgure 2.h. A negave shock o expor prces has a negave shor run effec on he rade balance (J curve effec) whch s followed by a more perssen mprovemen wh he rade balance. 6. Hsorcal shock decomposons The esmaed shocks can be used o provde a hsorcal decomposon of he daa (e.g., Chrsano e al, 2008). Fgures 3.a. 3.f. do hs for Spansh domesc demand componens (normalzed by GD) and he Spansh rade balance. To keep he analyss racable we only focus on he man shocks hghlghed, and group he conrbuon of all oher shocks no a resdual caegory referred o as "ohers". 8 Resdenal nvesmen (Fgure 3.a) Resdenal nvesmen was he man drver of he Spansh boom and bus cycle. The shock decomposon shows ha wo man shocks explan he resdenal nvesmen boom, namely negave shocks o he housng rsk premum (posve housng bubble), and a fall n he Spansh exernal neres rae spread. The laer only generaed a emporary ncrease n housng nvesmen. Ths s because he ncrease n house prces (due o land consran) sablze resdenal nvesmen. A prolonged boom n resdenal nvesmen can only be generaed by a housng bubble. Ineresngly, he shock esmaes sugges a ghenng of he loan-o-value rao for household morgages n he frs half of he 2000s; however, he ghenng was far from srong enough o compensae for he expanson of he collaeral value generaed by he bubble. We only 8 In he Fgures, he lne marked wh black damonds ndcaes observed daa. The caegory "ohers" combnes all oher shocks ncluded n he model (e.g. shocks o mark-ups) and ncludes he effecs of he nal condons. Dealed shock decomposons of oher varables ncl. employmen, un labour coss, real exchange and neres raes are avalable n he supplemenary appendx. 8

19 denfy a loosenng of he collaeral consran n he las years precedng he fall n resdenal nvesmen. Sarng n 2008, he housng bubble burss, and housng nvesmen (as a share of GD) declned srongly. The bursng of he bubble was accompaned by a ghenng of loan-ovalue raos. Consumpon (Fgure 3.b) Conrary o resdenal nvesmen, Spansh prvae consumpon has remaned relavely sable as a share of GD. Ths should no be nerpreed as f he facors drvng he resdenal nvesmen boom were unmporan for consumpon. Raher, he sably of he consumpon rao (whle resdenal nvesmen rose sharply) s due o rsng household deb. Ineresngly, he hsorcal decomposon shows ha he housng bubble conrbued negavely o prvae consumpon--everyhng else equal, he housng bubble would have led o a fall n consumpon (due o he srong rse n resdenal nvesmen rggered by he shock). However, hs effec was offse by he fac ha he fall n he Spansh neres rae spread allowed Spansh households o borrow more from he res of he world. Towards he end of he boom, a loosenng of loan-o-value raos sablzed he consumpon/gd rao. However, afer 2008 a collaeral ghenng ses n whch evenually reduces boh he consumpon and he resdenal nvesmen share Non-housng nvesmen (Fgure 3.c) roducve (non-housng) nvesmen ncreased as well from 996 onwards. A maor drver for hs was he declne n he Spansh neres rae spread whch lowered he borrowng capal coss for Spansh frms. As for household (morgage) loans, he esmaes sugges no loosenng of he collaeral consran facng frms durng mos of he boom, even a slgh ghenng. I s only owards he end of he boom ha he collaeral consran for frms s slghly loosened. In 202 he collaeral consran ghened agan. The nvesmen boom was also fuelled by low rsk premum for non-housng capal and by rsng employmen made possble by fallng wage mark ups. Accordng our resuls, he abrup declne of nvesmen durng he fnancal crss s assocaed wh a rse n he nvesmen rsk premum, a collapse n exernal demand and nsuffcen downward wage adusmen (whch amouned o a rse n he wage mark-up). Reduced lendng only played a mnor role. Unlke resdenal nvesmen, 9

20 durng he bus he producve nvesmen/gd rao dd no fall below he level reached n 999. Trade balance (Fgure 3.d) The facors drvng consumpon, resdenal nvesmen and producve nvesmen also shape he evoluon of he rade balance (see Fgure 3.d). The mos mporan drver of he rade balance unl 2008 was he declnng neres rae spread (whch ncreased all domesc prvae demand componens). Quanavely he housng bubble s less mporan for he rade balance because only sgnfcanly rases resdenal nvesmen, whch s a relavely small demand componen and even reduces prvae consumpon (va he households' budge consran) and non-resdenal nvesmen (va ncreasng neres raes). The collaeral ghenng for households and frms nally (early 2000s) had a posve nfluence on ne expors because of s negave nfluence on all domesc prvae demand componens. Anoher facor whch mproved he rade balance before 2008 was wage resran. Whle n he boom perod from 997 unl 2008 ne expors fell gradually, ne expors rose rapdly n he frs year of he fnancal crss, followed frs by a sablzaon a a hgher level, and hen by a furher noceable ncrease from 20 onwards. The nal rse was largely due o rade shocks, n parcular declnng mpor demand shocks. Household collaeral ghenng and a furher reducon of he rsk premum as well as fscal consoldaon were he man drvers whch have urned around he Spansh rade balance afer Our analyss suggess ha he correcon of he Spansh exernal mbalance was mosly due o deleveragng n he prvae secor and here largely he household secor as well as o publc deleveragng. There s a wde debae abou he role of srucural reforms for he rebalancng of he Spansh economy. In hs respec, we can dsngush fve possble measures of srucural adusmen, namely an mprovemen of echnology (from secoral resrucurng), labour marke reforms, fallng prce mark ups, fallng expor prce mark ups and ncreasng world marke shares. Our analyss suggess ha srucural reforms wll ake me unl hey have sgnfcan effecs. A leas up o he end of our sample perod, srucural goods and labour marke ndcaors are sll domnaed by negave afer effecs of he crss. The mos promsng srucural mprovemen seems o be a perssen rse n Spansh TF growh. For example he European Commsson esmaes an acceleraon of rend TF growh snce 2008 of around 0.2% p. a. However, sandard labour marke ndcaors such as NAWRU esmaes show rsng rends unl he end 20

21 of our sample perod. (Commsson esmaes an ncrease of he NAWRU from 5% (2009) o 2% n 202). Recenly, he Spansh cenral bank has repored prce mark-up esmaes whch show an ncrease from.2 (n 2008) o.3 (n 20) (see de Cos 203). These fndngs are roughly conssen wh our srucural shocks. There s a slgh posve effec of mproved producvy growh on he rade balance, however labour marke shocks exer a negave effec on he rade balance. We also denfy rsng mark-ups n he goods marke. Ths has offseng effecs on he rade balance va ncome and compeveness effecs and he ne mpac on he rade balance s slghly posve. Also rade shocks hemselves (e.g. fallng mark ups for expors, or ncrease n expors) have only played a mnor role over he recen perod. Ths should, however, no be msnerpreed, snce we only measure he mpac of shocks o expors and expor prces,. e. ncreases n marke share whch canno be explaned by a fall n he erms of rade or a fall n expor prces (fall n expor prce mark ups) whch canno be explaned by a fall n un labour cos. 7. Concludng remarks Ths paper has shown how an open economy DSGE model wh fnancal frcons and fnancal shocks can be used o analyses he drvng facors behnd nernal and exernal mbalances n he Spansh economy. Our esmaes sugges ha he key facors behnd hose mbalances were low real neres raes, lnked o he nflow of foregn capal, and a housng bubble. The perssence of he housng boom, whch s he mos noceable macroeconomc even n Span, can only be explaned by a perssen fall n housng rsk prema. Lendng o households and frms has accommodaed he growh n loan demand fuelled by he asse prce boom. The adusmen n he rade balance afer he fnancal crss s manly drven by he collapse n he housng bubbles, and a ghenng of lendng condons. The correcon of he rade balance reles mosly on a declne n domesc absorpon and a drop n mpors. The accompanyng deflaon and declne n un labour coss brng abou a furher deprecaon of he real effecve exchange rae. We fnd no srong evdence of excessve wage growh as a drver of he Spansh exernal mbalance durng he boom. Durng he Grea Recesson, he fall n house prces and ghenng cred condons have led o a gradual mprovemen of he rade balance--gher cred condons for households and fscal consoldaons are closely algned wh he rse n nex expors. Anoher facor conrbung posvely o he recen mprovemen n he rade balance s acceleraed TF 2

22 growh n Span. Fallng mark ups for expors, or ncreased expor demand have only played a mnor role snce he crss. 22

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25 Table Calbraed srucural parameers Srucural parameers c Calbraed value 0.35 NF house 0.0 Targe governmen. deb o GD 0.6 Targe governmen defc o GD ssc W W K 0.35 C c / 0.04 r, EUR / R b lag.5 y 0.4 mup Table 2 Esmaon resuls for man srucural parameers ror dsrbuon ror mean ror s.d. oseror mode oseror s.d. h ea κ Gamma σ H Gamma σ X Gamma σ Gamma σ L ea s s ea rprem ea β r ea CG τ lag ea CG τ ea τ ea τ DEF ea IG τ lag ea IG τ ea τ, IG ea τ DEF, IG ea rprem ea b U ea s ea

26 Fgure Span: 995Q-203Q2 Fgure.a.Annual. GD growh Fgure.b Consumpon/GD share Fgure.c Gross fxed capal formaon and consrucon nvesmen shares n GD Fgure.d House prces rel. o GD deflaor Fgure.e Nomnal neres raes Span and euro area Fgure.f Real neres rae Fgure.gTrade, curren accoun and governmen balance (% GD) Fgure.hGovernmen deb and nernaonal nvesmen poson (% GD) 26

27 Fgure 2. Impulse responses Fgure 2.a. Negave shock o housng rsk premum Fgure 2.b. osve shock o household loan-o-value rao 27

28 Fgure 2.c. Negave shock o exernal rsk premum (domesc neres rae spread) Fgure 2.d. Shock o frm loan-o-value rao 28

29 Fgure 2.e. osve shock o rsk premum on producve capal Fgure 2.f. osve shock o governmen consumpon 29

30 Fgure 2.g. osve shock o Spansh expor demand (preference shock for Spansh goods) Fgure 2.h. osve shock o expor mark-up: 30

31 Fgure 3.a: Shock decomposon resdenal nvesmen o GD rao 0.05 quarer o quarer E_ICONSTRY Technology Sock marke rsk premum shock Housng rsk premum shock Households fnancng condons Non-fnancal frms fnancng condons Exernal shocks Trade shocks rce markup Inernaonal capal flows Fscal shocks Shock o wages Ohers Fgure 3.b: Shock decomposon consumpon o GD rao 0.5 quarer o quarer E_CY Technology Sock marke rsk premum shock Housng rsk premum shock Households fnancng condons Non-fnancal frms fnancng condons Exernal shocks Trade shocks rce markup Inernaonal capal flows Fscal shocks Shock o wages Ohers 3

32 Fgure 3.c: Shock decomposon producve nvesmen o GD rao 0. quarer o quarer E_IY Technology Sock marke rsk premum shock Housng rsk premum shock Households fnancng condons Non-fnancal frms fnancng condons Exernal shocks Trade shocks rce markup Inernaonal capal flows Fscal shocks Shock o wages Ohers Fgure 3.d Shock decomposon rade balance-gd rao 0. quarer o quarer E_TYN Technology Sock marke rsk premum shock Housng rsk premum shock Households fnancng condons Non-fnancal frms fnancng condons Exernal shocks Trade shocks rce markup Inernaonal capal flows Fscal shocks Shock o wages Ohers 32

33 Fgure 3.e Shock decomposon NFA poson (4 shocks) 0.06 quarer o quarer E_TYN Impor Expor Impor prce Expor prce Ohers Fgure 3.f Shock decomposon GD growh 0. year on year E_GY Technology Sock marke rsk premum shock Housng rsk premum shock Households fnancng condons Non-fnancal frms fnancng condons Exernal shocks Trade shocks rce markup Inernaonal capal flows Fscal shocks Shock o wages Ohers 33