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Self-Fulfilling Debt Crisis – Is the European Debt Crisis finally over?

1.     Introduction

The European debt crisis had a long-lasting negative economic impact on European economies. The debt crisis resulted from the financial crisis in the United States which started with the collapse of the investment bank Lehman Brothers on 15 September 2008. The financial crisis came as a shock because it was not anticipated by policymakers and professionals. It caused a surge in debt levels, high unemployment and a sharp decline in economic growth. The crisis pushed several countries at the edge of bankruptcy as they were unable to cover their interest payments and roll over their government debt. The most severely affected countries included, Portugal, Ireland, Cyprus, Greece, and Spain. The precise causes underlying the debt crisis in Europe varied across countries. For some, the origin was traced back to a housing bubble, the currency union or excess government spending. During the height of the debt crisis, the International Monetary Fund (IMF), the European Central Bank (ECB) and the European Commission (EC), which formed the Troika, proposed structural adjustment programs which were to be implemented in the crisis countries. Many of the structural reforms were directly tied to financial support and made the financial support conditional on the implementation of the suggested measures. At the beginning of 2010, the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) were created to provide credit to crisis countries to close the refinancing gap. At the start of the crisis the ECB had aggressively lowered interest rates. Moreover, Mario Draghi, the head of the ECB, announced on 6 September 2012 to “do whatever it takes” to save the Euro.  Additionally, the ECB started the Outright Monetary Transactions (OMT) program in which bonds of Euro member states were purchased in the secondary sovereign bond market. In July 2014, Portugal and Ireland were able to exit the bailout programmes after economic recovery. However, many countries continue to have high debt levels. This raises the question of whether or not the European debt crisis has been solved. This paper first investigates the dynamics which triggered the European debt crisis. Second, the paper applies a model framework to analyse the role of risk perception and interest payments. Finally, it discusses if the debt crisis is over and highlights policy implications.

2.    European Debt Crisis

The yield on government bonds can be used as a measure of sovereign risk as it incorporates a default premium (Bodie, 2011). The interest payments can be considered as a compensation to investors for holding the sovereign debt. For sovereigns, the yield determines the cost of borrowing in the market. The analysis of the evolution of the 10-year bond spreads of European sovereigns is key to understand the debt crisis. Figure 1 shows that after the adoption of the Euro as a common currency, there was a strong convergence of 10-year bond yields among European economies. Yields remained at the same level until the breakout of the crisis. This suggests that investors were willing to lend countries such as Greece and Portugal money at the same rates as France or Germany, despite the fundamental economic differences. With the breakout of the crisis, market perceptions about the riskiness of sovereign changes and the yields started to diverge. Investors suddenly started to attribute higher risk to these bonds and required higher interest payments. This lead to a vicious cycle for some countries because they were unable to refinance their debt at higher rates. One of the indirect policy outcomes of the ECB’s monetary policy is the convergence of the 10-year bond yields before and after the crisis (Ehrmann et al., 2007; Praet, 2017). It is interpreted as a sign of the ECB’s monetary policy credibility in financial markets. In theory, any rational and risk neutral investor requires a compensation for the risk of his investment. The lender’s risk hypothesis states that the interest payments on government bonds must equal the risk-free rate divided by the probability of repayment (Lebre de Freitas, 2017). The arbitrage condition must be satisfied at any point in time. Ceteris paribus, investors require a higher compensation as the probability of repayment decreases.

3.    First Period – Europe before the crisis

The dynamics of the European debt crisis can be analysed within a two-period model (Lebre de Freitas, 2017). Therein, the period before the breakout of the crisis can be understood as the first period in which the debt-to-GDP levels of most of the European countries were at stable levels. This was also true for countries which were hit the most by the crisis. For instance, Figure 2 shows that Portugal, Spain and Greece had a debt-to-GDP ratio of 68.4%, 35.5% and 103.1% respectively. During this period, the credibility of all European economies in the debt markets was high as they were perceived to be solvent. The years up to 2008 can be considered as a virtuous cycle in which high credibility and market confidence made it possible for European governments to refinance them cheaply while they continued to invest. In some cases, the primary balance   was negative because governments spent more than their tax revenues. Figure 3 shows, for example, that Portugal, Greece and Germany had primary deficits whereas Spain and Italy had surpluses. However, the total government deficit in period 1 is not the decisive factor in determining the probability of repayment. It is determined by the revenue  which the government has available to repay its debt   in period 2. This revenue is the difference between the tax revenue and government minimal expenditure .  Therefore, rational and risk neutral investors continued to buy bonds, because they believed that the government can pay its debt obligations in the subsequent period, . This analysis makes clear that investors who bought European government bonds regarded them as a safe conglomerate and formed expectations about period 2 in which the European sovereigns were always solvent  . Therefore, they were willing to lend at such low rates. This led to a “good” equilibrium which was stable. Sovereigns had the ability to repay debt because the low interest rates and the credibility of a high probability of repayment were reinforcing each other.

4.    Second Period – Europe after the crisis

With the breakout of the debt crisis in 2009, debt-to-GDP levels of many European sovereigns sharply increased and interest rates on the 10-year government bonds started to diverge. In fact, the financial crisis in the USA can be seen as an external shock. The economic downturn put additional pressure on European economies and market expectations turned pessimistic. In 2010, the three big credit rating agencies started to downgrade many of the weaker European economies including Greece, Portugal and Spain. This reflected the high-risk perception in the market and the credit downgrades were strong signals to the market that the probability of repayment dropped. Thus, the sudden shock led to a new “bad” equilibrium with a lower probability of repayment and high interest rates. However, this exacerbated the situation for sovereigns to roll over their debts and triggered a vicious cycle. Higher interest payments made it more difficult to cover interest payments and roll over debt to the next period which in turn led to a higher probability of default. For example, Portugal’s and Greece’s interest rate on their debt rose to 12.81% and 29.24% respectively in February 2012. In the model, this “bad” equilibrium is not stable. It leads to downward spiral dynamics in which small open economies are unable to restore credibility by themselves once they experienced heavy financial distress. Another problem during crisis situations is coordination failure. As creditors start to demand higher compensation, they increase the sovereign’s risk of default. Because investors are relatively small and dispersed, it is hard to coordinate common actions. By demanding lower compensation, they could increase the probability of repayment and move back to the “good” equilibrium. However, investors did not have any incentives to do so but continued to impose a negative externality on other creditors. Yet, the ECB and the EU delivered coordinated policy responses by guaranteeing the Euro as a currency and providing financial support. In fact, the EU created the EFSF in 2010 and EFSM in 2011 to close the financing gap for member countries in need.  The idea of these policy responses was that crisis countries could overbridge the crisis periods in which market confidence was low and access to finance more difficult. These financial measures helped to restore credibility in the market which sent out signals about the higher probability of repayment. Investors were again willing to provide financing at lower cost because these actions were credible signals about the sovereigns’ solvency.

5.    Policy implications

The analysis shows that high debt levels were not the cause of the European debt crisis but rather the result of it. The two-period model stresses the importance of credibility, confidence and expectations in financial markets. Almost 10 years after the financial crisis and thanks to numerous policy measures, European economies have stabilized themselves. European 10-year government bond yields have started to converge quickly since 2013 and remained on average yield levels of 1.4% in 2017. Policymakers should analyse the current equilibrium in the same two-period model framework. There exist, however, remarkably differences in the pre-crisis status quo. The debt levels have skyrocketed for countries like Portugal, Greece and Spain because fewer tax revenues were collected, and private debt was bailed out during the crisis (Klein, 2015). The current situation can be seen as countries having reached their maximum feasible debt level . In the model, a unique equilibrium is obtained. Even though this equilibrium is stable, it is highly sensitives to changes in the fundamental factors. At this equilibrium, any small increase in the debt levels, would trigger the vicious cycle leading to default. In addition, changes in the risk-free interest rate would have the same effect.

This has strong implications for policy-making in the current low interest environment. As the ECB’s OMT program will gradually be reduced, a rise of the central interest rate becomes more likely.  Because of the lender’s risk hypothesis, investors would require higher interest payments. This raises the question about the sustainability of sovereign debt levels in the EU. So far, many of the long-term structural challenges remain unsolved. With high debt levels, the fear of defaults in the future will become apparent once economic growth slows again and no European crisis resolution mechanism is implemented. In a future crisis scenario, the fear of bank runs and contagion remain. Current discussion surrounding the sustainable level of Italy’s debt level show that expectations and credibility in the market play a central role. The debt crisis has shown, however, that expectations can change quickly. Slower economic growth or a loss in confidence may quickly reverse the achievements of the last years and trigger another self-fulfilling debt crisis. Overall, it cannot be concluded that the European debt crisis is over. Too many uncertainties, imbalances and frictions remain. Policymakers need to develop long-term solutions to tackle these major structural challenges and reduce debt levels through economic growth and balanced budgets. Crisis resolution mechanisms are needed to create long-term confidence, to build a more resilient and sustainable framework for the future in the EU.

Author:Paul-Leonard Glöckner (30730)


Bodie, Z., Kane, A., & Marcus, A. J. (2011). Investments. New York: McGraw-Hill/Irwin.

European Central Bank (2017). Statistical Data Warehouse. Retrieved from:

Ehrmann, M. & Fratzscher, M. & Gürkaynak, R. S. & Swanson, E. (2007). Convergence and Anchoring of Yield Curves in the Euro Area. European Central Bank, Working Paper Series.

International Monetary Fund (2017a). World Economic Outlook (October 2017) Database. Retrieved from:

International Monetary Fund (2017b). Public Finances in Modern History Database. Retrieved from:

Klein, E. (2015). Greece’s debt crisis, explained in charts and maps [Vox news]. Retrieved from:

Lebre de Freitas, M. L. (2017). Macroeconomic Analysis: Self-Fulfilling Debt Crisis [class handout]. Nova School of Business and Economics, Lisbon, Portugal.

Praet, P. (2017). The ECB’s monetary policy: past and present. Frankfurt am Main, Germany: European Central Bank. Retrieved from:


Figure 1. Long-term interest rate for convergence purposes – 10 years maturity

Figure 1

Source: own calculations based on data from the European Central Bank Statistical Data Warehouse.

Figure 2. General government gross debt-to-GDP ratio [%]

Figure 2.png

Source: own calculations based on data from the IMF World Economic Outlook October 2017.

Figure 3. Primary balance to GDP ratio [%]

Figure 3.png

Source: own calculations based on data from the Public Finances in Modern History Database.



(Ir)Rational Expectations and Cryptocurrencies: Next Step on Monetary Policy.

Investment Portfolios are getting flooded with cryptocurrencies and their behaviour is close to unforeseeable. Is the bitcoin a viable form of money? Should the Central Bank’s extend their price stability mandates to the crypto markets?

“… When you had what I wanted, or, I had what you were willing to take, a substance  which facilitated trade whose public and perpetual value, …coined by public authority, was created and called the price.” In ancient Rome, Julius Paulus Prudentissimus acknowledged that the true utility of a currency depends on its nominal properties. And so, currency efficiency relies on economic agents’ confidence on monetary system.

In 2009 (nearly 2 millennia later) a new transaction hub surfaced, Bitcoin. The first cryptocurrency, a decentralized, electronic cash system that facilitates digital transactions. Nowadays, there are over 1324 types of digital currency and this number is deemed to grow in the upcoming years. Dell, Microsoft or Tiger are already accepting bitcoin for online transactions and the simple act of acquiring a device has become attainable for someone with a wallet full of bitcoins.

Currency evaluation and Rational Expectations

While cryptocurrencies assert as a form of money, macroeconomic monetary theory starts to become under its scope. However, it is rather challenging to address such a volatile and unpredictable currency and several issues arise with its analysis.
On one hand, we are decomposing effects of a currency that, being decentralized, acts as an asset. Bitcoin is severely accompanied and essentially driven by risk perception and big market movements and capitalization. The real problem arises when one aims to measure that volatility, as the reasons for the risk faced by owning bitcoin is still unclear and so there’s no current volatility index accepted. Figure 1 depicts these volatility in the past few months, with variations of around 5000$ in two months.


On the other hand, the valuation of cryptocurrencies when compared to other fiat currencies. Are exchange rates between the dollar and the bitcoin trustable? Do they really reflect the true value of the digital money? It’s hard to tell. Stating that the Bitcoin or the Ethereum are overvalued when compared to the euro (current bitcoin valuation is 9518.97€) is not under scope as both are unalike. Cryptocurrencies allow owners to act under anonymity and are decentralized, these two facts cause the evaluation to be unrealistic (Scorer, 2017).

Then how do agents expectations adapt to uncertainty? In a Rational Expectations framework one should expect that for every “period”, agents would anticipate the value of the currency to be close to the past value subject to variations intrinsic to the models within which it behaves, as it is their best guess as educated agents. However, the foreseeable fraction of the cryptocurrency evaluation seems to be of null effect. Its volatility appears to be the main driver of its value, and so the agents cannot define their expectations in accordance as they do not know the sources of risk perception (they cannot evaluate the model properly). In fact, any guess regarding the true value of the Bitcoin is no more than that, an uninformed guess. A good illustration of this fact is the negative fluctuations that happen on value when there’s a day of bad advertisement for the bitcoin, “digital animal spirits” arise and agents are acting based on collective realizations.

Next Step: Innovative Monetary Design For Central Banks

Cryptocurrencies have been successful at getting rid of a centralized monetary authority, giving up the flexibility of an elastic supply of money. In fact, the Bitcoin supply is fixed at a certain level (calculated by an algorithm) to prevent malicious issuance of the currency.

Then, what is the range of monetary policy? In a world where digital payments have become increasingly popular – In Sweden and Denmark (Nicolaisen 2017) electronic payments have started to crowd out the use of cash – and where technology is allowing for more efficient construction of algorithms, a Central Bank Digital Currency (CBDC) is starting to be in the centre of the bullseye of economic research. Ethereum or Bitcoin are impossible to control by a rule or a specific mandate, as they are a private algorithm. However, a CBDC would ease the expectations and diversify the supply of money creating a variety of benefits (Bordo and Levin, 2017):

  • Costless medium of exchange. Additionally, the introduction of the CBCD would facilitate more rapid and secure settlement of cross-border financial transactions (He et al. 2017).
  • Risk-Free asset.
  • Base digital currency for private cryptocurrencies. Would create a trustable digital currency from which other cryptocurrencies, like Bitcoin or Bitcoin Cash, could be compared. For example, a spread between a CBDC volatility ratio and Bitcoin volatility ratio (assuming that one could be found over time) would give a good measure of risk for Bitcoin. Also, a comparison between the digital currency values could serve as a measure for undervaluation or overvaluation of a cryptocurrency.
  • Price Stability. Central Bank Digital Currency would give households and businesses confidence that a “basket of consumer items” would be stable over the medium and long run horizon acting as an easing of expectations. The relationship between agents and the central bank would be more transparent, promoting socially efficient allocations.

Under Rational Expectations, this natural extension of current trends in monetary operations would allow for a more efficient maximization of social welfare by the Central Bank. A risk free form of money joined with a secure price stability rule, would secure an alignment between agents expectations and the Central Bank actions. Furthermore, comes the control of pre-existing digital currencies, having a risk free comparable currency would provoke a more trustworthy valuation of other cryptocurrencies and less risk of an expectations crisis and in extreme cases, a bubble (Rogoff, 2016).


As digital currencies are treated as a mean of transaction and as technology development is increasing, it’s indispensable to reflect on the consequences of a wider use of cryptocurrencies in anticipation. Central Banks and monetary institutions cannot defy the risks of being passive on an issue like this. As big enterprises are accepting bitcoin for transactions, the risks of an uncontrolled currency become wider. In the years to come macroeconomists will surely undergo a broad discussion on the merits and downsides of the CBDC.

In the short term, this rational expectations crisis might not have a direct effect on the economy in a macro level. Nonetheless, in the long term where cryptocurrencies might be the most popular mean of transaction (due to its security and its digital properties), blurry expectations are a severe issue and so, government and monetary pressure is needed. Stiglitz (2017) affirms that this pressures will be the reason for the current expectations crisis to blow up, but if it is so, then the cryptocurrencies will avert to their true value over time. In a distant time horizon, this visible hand of the Central Bank Digital Currency, will be of utmost importance to limit agents’ expectations (through price stability) and give credibility and viability to a developing configuration of money.


  • Scorer, S (2017), “Central Bank Digital Currency: DLT or not DLT? That is the Question”, Bank Underground, 5 June.
  • Bordo, M and A Levin (2017), “Central Bank Digital Currency and the Future of Monetary Policy”, NBER Working Paper No. 23711.
  • He, D, R Leckow, V Haksar, T Mancini, N Jenkinson, M Kashima, T Khiaonarong, C Rochon, and H Tourpe (2017), “Fintech and Financial Services: Initial Considerations”, International Monetary Fund Staff Discussion Note 17/05.
  • Nicolaisen, J (2017), “What Should the Future Form of Our Money Be?” Speech at the Norwegian Academy of Science and Letters, 25 April.
  • Rogoff, K (2016), The Curse of Cash, Princeton, NJ: Princeton University Press.
  • CNN MONEY, “Nobel winner says bitcoin ‘ought to be outlawed’”, Ivana Kottasová, 1 December 2017

Bruno Carreiras, 22018.

The time-inconsistency problem: Evidence for the period of inflation targeting in Colombia

The problem of temporal inconsistency arises when a policymaker makes an announcement of a policy, but at the time of its implementation, performs another; this after people have already taken their decisions based on the first announcement. In doing so, policymakers are trying to improve the economic welfare of society, but these inconsistent actions will eventually lead to other outcome.

The intervention of the state in economics was justified through Keynes’s Macroeconomic Theory (1936), which arose after the Great Depression in 1929. Around 50, it was believed that the best way to conduct monetary policy was through the opacity of the Central bank shares, as it would be easier to obtain the desired results (MENDONÇA, 2006).

The Keynesian Model, however, was losing supporters because of the lack of microfoundation, which invalidated the policy councils based on conclusions of large-scale macroeconomic models. Lucas’ Critique (1976) was based on the fact that the parameters of these models were not invariant relative to politics, since they would necessarily suffer changes.

The rise of neoclassical ideas was led by Robert Lucas and followed by other economists who supported the revolution on rational expectations (MONTES, 2009). In this model, individual agents will base their decisions on the best information available, though people may be wrong some of the time, on average they will be correct and they are the best guess for the future. That is assumed that people learn from past mistakes.

The incorporation of rational expectations to economic policy and contrary evidences to the Keynesian approach, which associated with the trade off inflation versus unemployment present at the original Phillips curve, led to a change of this pattern in the theoretical analysis of politics Monetary, which was reference until mid-1970 (MENDONÇA, 2006).

From then on, the argument that monetary policy should be concerned with low and stable inflation has been supported by rational expectations and the natural rate of unemployment. The theoretical justification for adopting the inflation targets regime began with Kydland and Prescott (1977), known as “rules versus description”. They initiated their studies on the credibility of monetary policy where they stated that the use of rules for driving would represent the best solution for the current policy to be consistent with the future equilibrium policy.

Following this same line, Barro and Gordon (1983) highlighted the importance of the role of reputation for conducting monetary policy, since persistence of inflation is attributed to non-compliance with the ads previously signed with society. In this way, it has become necessary to seek ways to resolve the problem of inflationary bias arising from monetary policy. According to Barro (1986), the disinflation of the economy can result in a greater sacrifice than necessary for society.

According to Inhudes and Mendonça (2010), the current trend for central banks is to increase transparency for the conduct of monetary policy. In line with this thinking, since 1990 the inflation targeting regime has been adopted by several central banks. The main characteristic is the announcement of levels for the fluctuation of inflation, recognizing that monetary policy aims to maintain low and stable inflation (MONTES,CURI, 2014). The adoption of this policy is linked to greater transparency of the central bank, increasing its responsibility and also credibility.

Mishkin (2004) studied the issues that need to be addressed in order for the inflation targeting regime to work effectively in emerging economies. He argued that the developments of fiscal, financial and monetary institutions are key to achieving successful implementation. According to him, this regime results in a reduction in the problem of inconsistency and increase in the accountability of the economic policy-maker.

Mendonça et al. (2012) analyzed the policy of adopting inflation targets for developing economies and concluded that it represents a good strategy, since it reduces the volatility of inflation, leading to acceptable levels in the international scenario. In general, developing economies have experienced hyperinflation, resulting in a fragility of central bank communication and transparency.

In this way, the analysis of the effects caused by the expectation of inflation is important for the developing economies. This analysis seeks to answer whether the inflation targeting regime is able to mitigate discretionary actions by the Central Bank of Colombia and, therefore, the occurrence of the problem of inconsistency over time.Colombia adopted inflation targeting in November of 2001 and the analysis focuses on the period after the adoption of inflation targeting, from 2001 to 2014.

The constitutional mandate to maintain a low and stable inflation, in coordination with general economic policy is the Junta Directiva del Banco de la República’s (JDBR) responsibility. The model was adopted to control the actions of monetary policy, maintaining a low inflation rate and achieving a level of output consistent with the capacity of the economy. In Colombia, the goal refers to inflation in consumer prices, which is measured by the annual variation in the Consumer Price Index (IPC), calculated by the National Bureau of Statistics (DANE).

In 1991, the JDBR decided to abandon the currency bands regime, implementing a flexible exchange rate regime and the first Report on Inflation was published. Later, new indicators and predictive models were built to allowed the consolidation of the strategy targets for inflation. In November 2001, the JDBR reported that long-term target for inflation was 3% and explained that maintaining the purpose was equivalent to lean towards a price stability in the country. In 2002 it was given the beginning of a track around a specific goal for the coming year, in order to control the growth of prices of the basic basket of families and ensuring the purchasing power of money. Thus, in mid-2009, inflation was around 3%, and as of 2010 the band established goal, which was between 2% and 4%, has focused on the long-term goal.

Monetary policy decisions are made based on the current analysis of the state from the perspective of the economy as well as in evaluating the forecast and expectations of inflation considering the long-term 3% target. Thus, the Junta Directiva del Banco de la República determines the value of its main monetary policy instrument, the basic interest rate. This fee level will allow to stabilize inflation in the policy horizon, ranging from 6 months to 2 years, in 3% and contributes to the product converge to long-term level.

The main criteria for setting the basic interest rate are:
• When the present analysis and future inflation indicate that there is possibility of permanent deviation of 3%, the prime rate changes to lead the inflation, in sufficient time, to the long-term goal.
• The intervention in the basic interest rate in order to maintain an appropriate balance between the achievement of the inflation target and the purpose of smoothing fluctuations in product and employment around its path of sustainable growth. That means that Colombia’s inflation strategy is flexible: it concerns keeping inflation at 3% and to avoid overspending or overproduction capacity.
• Banco de la República’s policy also seeks to contribute, together with other responsible entities, to mitigate the risk of financial statements unbalanced, those were understood as leverage excesses of assets or prices thet compromises financial stability. Avoid these imbalances makes it easier so the economy work close to its path of sustainable growth horizons of medium and long term.

These criteria should be incorporated seeking a balance between them. The basic interest rate adjusts gradually, except in conditions in which, with a high probability or certainty, the economy threatens to deviate considerably from the inflation target and/or its path of sustainable growth.

In the seminal article of Ireland (1999), the time-inconsistency problem is studied by testing the existence of cointegration between inflation and unemployment rate series. In the work of Gupta and Uwilingiye (2010), the time-inconsistency problem is studied by testing the existence of cointegration between inflation and GDP. In the present article, we will consider the results of both cointegration tests: inflation and unemployment series as well as inflation and output series.

A necessary condition for testing for a long-run relationship between two variables is that these variables are I(1), i.e., stationary in first differences. Once that it is observed it is possible to proceed to test for a long-run relationship between the series. If such a relationship exists and the signs of the coefficients are positive, it is possible that the time-inconsistency problem is occurring.

Regarding the findings for the relation between inflation and unemployment and for the relation between inflation and output, the results do not support the model’s implications for the long run, and thus monetary policy is not inconsistent. The findings suggest for 2001-2014 that inflation and unemployment are not cointegrated. In this sense, considering the monetary authority’s possibility to exploit the trade-offs in the Colombian economy, it seems that, under inflation targeting, there is no strong evidence of time-inconsistency problem of the monetary policy for the period.

The Colombian experience with inflation targeting looks quite successful. Inflation fell from levels above 15%, when inflation projections were first introduced, to a level around 3%. The results allow one to conjecture that the traditional argument that the adoption of inflation targeting can avoid the time-inconsistency problem is true for the Colombian case. Although developing countries present a fertile ground for the occurrence of the time-inconsistency problem due to the history of weak institutions and lack of commitment on the part of policymakers, this is not the case when Colombian is considered.



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BARRO, R. J. Recent developments in the theory of rules versus discretion. The Economic Journal, v. 96, p. 2337, 1986.

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INHUDES, Adriana, MENDONÇA, H.F. Transparência do Banco Central: uma análise para o caso brasileiro. Revista de economia política. Vol. 30. nº 1. São Paulo. Março 2010

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MENDONÇA, H. F., de GUIMARÃES e SOUZA, G. J., 2012. Is inflation targeting a good remedy to control inflation? Journal of Development Economics 98(2), 178-191.

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MISHKIN, F. S. Can inflation targeting work in emerging market countries?

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MONTES, G. C. Política monetária, inflação e crescimento econômico:a influência da reputação da autoridade monetária sobre a economia. Economia e Sociedade, Campinas, v. 18, n. 2 (36), p. 237-259, ago. 2009.

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Key Words: Sovereign Debt Crisis; Real Exchange Rate; Secular Stagnation

The European sovereign debt crisis occurred with a subprime crisis which started in 2007 in United States of America, with a “bubble” in the real estate devaluation. It is known for a “bubble” since it had repercussions throughout the economy. It happened when people had bought many houses in the real estate market by means of mortgage loans, but these houses had devalued and banks were led into a situation of insolvency. In order to correct the situation, American banks sold these mortgages to European banks that bought expecting them to valorise their systems, but these were “toxic” assets which affects negatively and deregulated the European banks, so a real estate crisis became a bank crisis. In summary, this bank crisis was motivated by unrestrained concession of real estate loans, as well as by failures in the regulation of the financial system that allowed a transfer of the mortgage credits risks to other counterparts.
Following the banking crisis, banks held many titles of sovereign debt and the risk was that the bank’s debt contaminate the sovereign debt and these “toxic” assets contaminate other financial assets that affect the state and created a propagation effect.
The rating agencies began affirming that the states would not pay the creditors, interest began to rise, and the assistance appears. The markets fear that states did not pay sovereign debt. The first country to need help was Ireland. They needed the Troika intervention. It was composed by financial institutions such as the European Central Bank (ECB), the International Monetary Fund (IMF) and the European Financial Stability Facility (EFSF). Ireland was not the only country needing help, Portugal and Greece were the followed.
Remember the Portuguese case, in May 2011, without the possibility of going to the market to get money, they failed to repay or refinance their public debt since they did not have access to the monetary assistance and within an economic crisis and high interest, Portugal had Troika’s intervention. The banks did not grant credit and the market crisis became an economic and credit crisis. The unemployment went high, reached its maximum, in 2012, with 17.5% and it was the point when the economic crisis became social. In 2012, the Portuguese President said they would be in a “recessive spiral”, the GDP decreased, the unemployment increased, the public expense increased with unemployment subsidies and the deficit increased. Briefly, with excessive amount of sovereign debt, lenders had demanded very high interest rates from Euro zone countries with elevated levels of debt and deficit, making it more difficult for these countries to finance their budget deficits when faced with low overall economic growth. Some countries have raised taxes and reduced expenses to combat the crisis, which has contributed to social suffering within their borders and a crisis of confidence among their leadership.
Related to the monetary capacity of each country, the effective exchange rate (REER) concept is the weighted average of a country’s currency against an index of other currencies, adjusted for the effects of inflation. This is an important measure when conducting economic analysis and policy making possible to a country to positively affect its REER through rapid productivity growth. Thus, the country has lower costs and can reduce prices, making REER more advantageous. When this happens the country’s trade capacity increases, and their current import and export situation will present better results.
In Europe, the European Central Bank (ECB) doesn’t change currency and the countries do not have this instrument, but when the euro valorise, these damages the poorer countries in their trade balance, leading to an asymmetry between the European countries.
When the economy was with inflation, in order to correct the indicator, the countries should devalue the euro to cancel out the effect and bring down prices to sell more and export more. If the adjustment is not made by the currency, another possibility is by the real market, with lower wages. The industry that has left Europe in the direction of East, Southeast Asia and Africa goes out in search of cheap labour. It raises unemployment, the prices fall, and consumers do not buy, firms accumulate stock because they cannot sell to the domestic market, so the solution is to divert this stock to the foreign market. This performance will allow to increase exports and decrease imports, improving the commercial balance, this situation only results if companies sell their surpluses.
ECB has no objectives in fighting against deflation, it focuses a lot on inflation rate, and European countries belongs to the ECB the monetary policy, the currency instrument, and the currency sovereignty had been lost and this lost hasn’t been compensated in the European plan. Deflation is a negative decline in prices, unlike disinflation which is a slowing of inflation rate. The worrying thing is when the deflation becomes disinflation. With inflation that is a generalized increase of prices, the exports become more expensive and decrease their value because countries like China sell cheaper. Countries cannot correct their trade balance because they cannot change the value of the currency, devalue it to increase exports, and thus correct the deficit, or decrease imports by valuing the currency because they are more expensive.
Following the above mentioned subprime crisis, economy should recover according, but some countries stay in secular-stagnation. This means that a sustained slowdown in economic growth, with very low investment. Economies of the world suffer from an imbalance resulting from an increasing capacity for economy and a decrease in the propensity to invest. The result is an excessive economic act on demand, reducing growth and inflation and the imbalance between saving and investment decreases as real rates. Demography also partly explains why the investment is so low. Population growth means that people need more things, which means low demand and companies invest in new workers and equipment. Slower growth in the workforce means slower overall growth and if there are fewer employees to hire. An example is the US economy that has not presented the expected growth results, in the GDP and in the employment rate, it presents a slow recovery of the economy.


NOVA SBE – MACROECONOMIC ANALYSIS    # 801                                    4th DECEMBER 2017

Venezuela’s mismanagement of oil reserves

According to international statistics, Venezuela has the largest proven oil reserves of the world. So, one has to ask, why experienced Venezuela a freefall in its economy, although it was at the beginning of this century the richest country of South America. Hugo Chavez, the president of Venezuela between 1999 and 2013, was always very popular among the poor and the middle class. One of the reasons was his promise to make the life of the poor better, by sharing the country’s oil revenues with the poor. Billions of dollars were spent on building houses, hospitals, providing food and other projects with broad support from the poor. Although he promised to also diversify the economy and invest in new industries, oil revenues accounted for 96 percent of the export in 2012, compared to 80 percent 10 years before.

Having an export that mainly depends on oil is not new for Venezuela, since the oil industry really developed in 1929, it started to dominate other industries. If a government mismanages such a natural resource, it creates a “Dutch disease” problem. This problem arises if the revenues of the oil industry only increases domestic demand. Meaning that demand for tradable as for non-tradable goods expands. This demand expansion causes an increase in the price of non-tradable goods, as the price is set domestically, yet the price of tradable goods does not experience a large change, as prices are determined in the international economy. The decrease of the relative price of the traded good in terms of the non-traded good is also known as a real exchange rate appreciation, this causes a problem because labour reallocates from the traded good sector to the non-traded good sector. Yet other reasons may also cause fluctuations in the real exchange rate.

The IMF performed a study to analyse the determinants of the real exchange rate for Venezuela between 1950 and 2004. They found the oil prices had a significant effect on the time varying real exchange rate, as a higher price allows to spend more on tradable and non-tradable goods. Besides the oil price, the paper emphasizes that policy choices and productivity differentials with other countries are an important determinant of the real exchange rate. Which illustrates that the latest economic crisis of Venezuela, isn’t caused by a sole factor.

As the oil price had a significant effect on the real exchange rate between 1950 and 2004, it is expected that the rise in the oil price between 2008 and 2015 also had an effect on the real exchange rate appreciation for Venezuela for that same period. Without doing a time series estimation for the effect of the oil price, observing from figure 1 and 2, one can see there is a clear correlation between the oil price and the real exchange rate after 2004. Yet, there may be again other determinants that also explain the real exchange rate appreciation after 2014.

Schermafbeelding 2017-11-29 om 16.14.28

Figure 1: Brent crude oil price (2010=100)

Schermafbeelding 2017-11-29 om 14.58.58

Figure 2: Real exchange rate index Venezuela (2010=100)

One of these other determinants that also explain real exchange rate appreciations according to the same study of the IMF in Venezuela between 1950 and 2004 is government spending. The study found that a higher government spending, causes a real exchange rate appreciation and that periods of oil price increases go along with a higher spending level. Furthermore, the paper states that during oil price booms the government also spent more. Yet as government spending, increases the real exchange rate, this policy amplified the effect of the rising oil price. And just like in the past the government under Chavez kept on financing their social program with oil revenues during the boom of the oil price. Besides the revenue coming from oil, Chavez could also rely on enormous foreign loans to pay for the social program. Foreign countries were very willing to lend to Venezuela, since the price of oil was still going up. Although many economists would recommend to save in good times and to spend the savings in bad times, Venezuela decided to spend its oil revenues…

Besides the oil price increase and government spending, that led to an exchange rate appreciation and correspondingly the “Dutch disease”, other factors also contributed to a further de-industrialization of the Venezuelan economy. In accordance to the social program of reducing inequality, the government took over hundreds of private companies, with the goal to redistribute the wealth among the poor. Yet these companies were badly managed, causing production to fall further.  Additionally, since 2003, the government imposes currency exchange controls, meaning that the dollars companies needed to import goods could only be bought from the government. Which contributed to a further decrease in local production. The exchange control originated as a reaction to the strike of the oil industry, which threatened Venezuela’s ability to repay its foreign debt. As long as Venezuela was able to borrow from other countries, the government could sustain this deficit and buy all the necessary imports. E.g. the government imported goods and sold them at a subsidized price to make food affordable to the very poor. However, this does not mean this was a healthy situation for Venezuela’s economy, because of its high spending and overall scarcity of goods, the average inflation before 2012 was around 15%.

However, from 2013 onwards, the situation changed dramatically. When Chavez died in March 2013, Venezuela experienced a sudden stop of capital inflow as foreign countries were not willing to give any more loans.  And late 2014, oil prices dropped to half the price, making it even harder for Venezuela to repay its debt. The Venezuelan government responded by tapping its gold reserves and printing money. This allowed them to pay off some of its debt and import some basic goods. But with the reserves declining, the government gave priority to paying off its debt over importing goods. They namely assumed a default would be too costly as many of their assets would be seized by creditors (e.g. oil refineries).  As a result, subsidies for food had to decline. To compensate, the government implemented the fair price law. This regulated the production and pricing of products, making companies less profitable and forcing them to stop production. The combination of money creation and goods that became even more scarce, led to a hyperinflation, with rates hitting 800%.

To get out of this situation, Venezuela has to move from an external deficit to an external surplus. It should try increasing its industrial activity and hereby reinstating an economy that is not only focused on oil revenue. Instead, it should focus on the export of other goods than oil. To establish a bigger workforce in the export or the traded good sector, Venezuela needs a real exchange rate depreciation. Which means either an increase in the price of tradable goods or a decline in the price of non-tradable goods or a combination of both. When wages and prices are flexible, such an adjustment can easily be achieved. Yet, the seating government, led by president Maduro has been repeatedly increasing the minimum wage in order to protect people against the high inflation rate. If the country allowed the nominal exchange rate to depreciate it would still be possible to have a real exchange rate depreciation. Such a nominal exchange rate depreciation would support the traded good sector, since it makes products cheaper for those countries with other currencies. Yet Venezuela’s government is holding the value of the bolivar fixed against the value of the US dollar.  The argument is that a depreciated bolivar would make it impossible to repay its debt and imports for the country would become much more expensive. With the two instruments to achieve a real exchange rate depreciation being fixed, the only way for the economy to meet external balance is through a contraction of demand. Which implicates there will be unemployment. According to the IMF, Venezuela had an unemployment rate of 17 percent in 2016 and it will grow to more than 36 percent by 2022. Even without these nominal rigidities, for Venezuela to achieve labour moving back to the traded good sector may be difficult due to structural rigidities such as a loss of skills, delay in investments due to uncertainty, borrowing constraints, …

This overview showed how the Venezuelan government badly managed the natural resource and how difficult it will be to get out of this current situation. As part of the economic recovery, current president Maduro, announced a devaluation of the currency in 2016. Yet analysts claim this devaluation is not yet sharp enough. And very recently, president Maduro announced the creation of a virtual currency, the Petro. He said that the currency will allow Venezuela to repay its debt and to overcome the financial blockade of the US. Future will tell if this is the measure Venezuela was waiting for.

Jef Jamaer (31338)



Figure 1: Brent crude oil price (2010=100). TRADINGECONOMICS. Accessed Nov 2017.

Figure 2: Real exchange rate index Venezuela (2010=100). International Monetary Fund, International Financial Statistics. Accessed Nov 2017.


Benzaquen, M. (2017, July 16). How food in Venezuela went from subsidized to scarce. Retrieved from:

Borger, J. (2016, June 22). Venezuela’s worsening economic crisis – the Guardian briefing. Retrieved from:

Brahmbhatt, M., Canuto, O. Vostroknutova, E. (2010, June 21). Dealing with Dutch disease. Retrieved from:

Venezuela: a nation in a state. (2016). Retrieved from:

Zalduendo, J. (2006). Determinants of Venezuela’s equilibrium real exchange rate. IMF working paper, Vol., pp 1-19.

Japan’s Never Ending Trap: Two decades of economic stagnation

The production of goods and services gives rise to income that is devoted to either the purchase of consumer goods and services or saving which is equal to investment spending. This notion leads us to the fact that the aggregate demand and the aggregate supply will be in equilibrium. This way, rationally, it’s easy to understand the assumption that under standard economic theory, an economy should not face a problem of insufficient aggregate demand.

Although theoretically no economy should be faced with a problem of this nature, in the real world it may not happen like this. One specific reason for the aggregate demand to be behave insufficiently was a phenomenon inherent to the Great Depression, denominated as “Liquidity Trap”. This singularity implies that the central bank is incapable of expanding aggregate demand, this is, if an expansion in the money supply is not followed by a decrease in the interest rate, it means that the central bank is impotent as to influence consumption and investment. It also implies that a decline the price level (followed by an increase in real money balance) does not mean that the demand for goods and services will increase.

In a liquidity trap, consumers prefer to keep their funds in savings rather than investing in bonds because of the prevailing belief that interest rates will soon rise. Given that there is an inverse relation between the price of a bond and the interest rate, the majority of the consumers don’t see as desirable to possess an asset whose price is expected to decline.

Japan’s current economic situation is a viable example of the phenomenon in question. For a couple of decades now, some of the most important economic indicators of this country have been proved to be in a delicate condition: nominal GDP has been stagnant for almost 25 years; real GDP has been essentially flat since the mid-1990s; nominal short-term interest rates have been close to zero; nominal long-term interest rates, as measured by the yields of Japanese government bonds, have also been extremely low for many years, while the Bank of Japan’s monetary policy has been highly accommodative for decades.

Japan seems to be caught in an economic and financial situation incapable of reviving growth, given the accommodative monetary policy in practice, portrayed by low nominal interest rates and an elevated balance sheet of the central bank. The fact that monetary easing has been unable to overcome deflationary trends, combined with the fact that gross domestic business fixed investment has not responded favourably to low nominal interest rates, come to corroborate the idea that the central bank has become unable to influence consumption and investment through monetary policy.

Japan’s economy was, arguably, the most powerful in the world in the 1980s, in which it grew at an average annual rate, as measured by the GDP, of 3,89% when compared to 3,07% in the United States. However, Japan’s economy fell into a hole in the 1990s. From 1991 to 2003, the country’s economy grew only 1,14% annually, way below when compared to the other economic potencies in the world.

Starting in the fall of 1989, Japan’s equity and real estate bubbles burst. Equity values plunged 60% from late 1989 to August 1992, while land values dropped throughout the 1990s, falling an incredible 70% by 2001.

This events required an efficient intervention by the country’s central bank, but in reality, it’s highly acknowledged that several mistakes were made when treating this sensitive situation: the Bank of Japan, concerned about inflation and asset prices, decreased the money supply in 1980s, which may have contributed to the bursting of the bubble; then, because the value of equities continued to go down, the Bank of Japan kept increasing the interest rates since there was still concern about real estate values, which continued to appreciate; these higher interest rates contributed to the end of increasing land prices, but also resulted in the overall economy slide into a downward spiral. With these procedures, in 1991, as equity and land prices fell, the Bank of Japan dramatically reversed the strategy and started to decrease interest rates, which revealed to be too late as the liquidity trap was already in place, and credit crunch was already setting in.

In 2001, the Bank of Japan instead of targeting interest rates, began to aim at the money supply, which helped moderating deflation and stimulating economic growth. However, when a central bank injects money into the financial system, banks are left with more money in its possession which implies that they must be willing to lend that money out. This lead to another problem in Japan’s economy, the credit crunch, which has been highly regarded as the main reason for the ineffectiveness of monetary policy.

This phenomenon of credit crunch is an economic scenario in which banks have tightened lending requirements and for the most part, do not lend. One of the reasons for not lending is the need to hold onto reserves in order to repair their balance sheets after suffering losses, which happened to Japanese banks that had invested strongly in real estate. When banks are reluctant to lend, it’s difficult for the economy to grow. In the same manner that a liquidity trap leads to deflation, a credit crunch is also conductive to deflation as banks are unwilling to lend and, therefore, consumers and businesses are unable to spend, causing prices to fall.

Having said this, it’s easy to conclude that deflation causes lots of problems. When asset prices are falling, households and investors hoard cash because it will be worth more tomorrow that it does today. This leads to the creation of a liquidity trap. When asset prices fall, the value of collateral backing loans falls, which in turn results in bank losses. When banks suffer losses, they stop lending, creating a credit crunch. Most of the time, we consider inflation as a very troubled economic problem, which it can be, but re-inflating an economy might be precisely what is needed to avoid prolonged periods of slow growth such as the one Japan experienced in the 1990s. However, re-inflating an economy isn’t easy, especially when banks are unwilling to lend.

Finally, it’s important to analyse some important solutions advocated by the mainstream economists. Krugman and Bernanke support solutions to this problem that ultimately rest on the quantity theory of money. These solutions consist of making a trustworthy commitment to a constant increase in money supply and the expansion of the central bank’s balance sheet. Following this point of view, the concern for the central banks must be inherent with an increase in inflation expectations into perpetuity, primarily through increasing high-powered money with the expansion of the central bank’s balance sheet. This solution implicitly assumes that monetary accommodation would eventually lead to higher expectations of inflation and induce risk taking due to the effect of an increased monetary stock on aggregate demand, in such view that the nominal interest rate should be lowered as much as possible, thus inducing investment and consumer spending. However, if the nominal interest rate cannot be lowered beyond some lower bound, then the central bank must engage in the purchase of long-duration assets and therefore reduce long-term interest rates. Krugman’s main policy proposal for when a given economy is trapped in such phenomenon is for the central bank to credibly promise “to print more money in the future, when the zero lower bound no longer binds”.

For both these economists, it’s “simple”: get the central bank to credibly commit to produce inflation. This because they blame the Bank of Japan of not being able to pursue the right paths in order to create inflation and reset inflationary expectations among the public and investors. In their point of view, the Bank of Japan lacked credibility. Paraphrasing Krugman, “if monetary expansion does not work it must be because the public does not expect it to be sustained”. The Japanese economy cannot get out of the liquidity trap because the real interest rate stays high, as the central bank’s failure to credibly commit to monetary expansion means that inflation and inflation expectations stay low or that deflationary pressures persist.


[1] Tanweer Akram (2016), Thrivent Financial. Japan’s Liquidity Trap.

[2] Krugman, Paul (2000) Thinking About the Liquidity Trap. Journal of the Japanese and International Economies.

[3] Krugman, Paul. (1998). ‘‘It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap.’’ Brookings Papers on Economic Activity.

[4] Krugman, Paul. 1998b. “Japan: Still Trapped?”

[5] Spiegel, Mark. 2000. “Inflation Targeting for the Bank of Japan?” FRBSF Economic Letter2000-11

Pedro Filipe Lima, 3678

Ricardo Vs Reagan: theory Vs practice

The Ricardian Equivalence is a proposition by Ricardo and Barro stating the timing of lump-sum taxes does not matter for consumer spending, so temporary tax cuts will not expand spending (unchanged demand) because what consumers consider is the present value of their after-tax income. Once the government announces a tax cut, while keeping or even increasing government spending (i.e. the theory requires the cut not be offset by government spending cuts), consumers see their disposable income increase, ultimately increasing their spending (boosting demand and consequently the economy). However, as individuals are considered rational, they perceive the government must raise debt currently if it is raising investment meanwhile cutting taxes, which implies in the future, to repay its debt, the government will increase taxes. Therefore, if consumers are aware of this process and its implications, the Ricardian Equivalence predicts an increase in savings rather than an increase in expenditure in the period of the tax cutting to finance the future period of increased taxation.

The timing of this discussion could not be better as following the 2008 economic crisis, economists started returning to more Keynesian economic approaches [1] (demand driven), truly observed during President Obama´s mandates, in which payroll taxes were cut in $120 billion as part of a $787 billion economic stimulus package launched [2]. However, the results of these policies, by 2009, were rather disappointing the administration, as taxpayers were saving most of what they got through the tax cut (for each “new government dollar, consumer spending rose just 8 cents”) and giving some space for Ricardo´s theory to shine [3]. Now, with a republican administration, the economic stimulus proposals surely will come from the supply side, as for example, the proposal to cut corporate taxes from 35% to 20%, adding to lower personal income taxes, through increased deductions and less federal income tax brackets [4]. Therefore, it is important to look at the consequences of similar pursuit strategies in the past to avoid committing to future strategies that will not produce the desired effects. Baring this in mind, the following analysis will discuss the strong assumptions the model requires and their need to be relaxed once we move to the real world, leading to the failure of the Ricardian Equivalence. The empirical case of President Reagan´s pursuit supply driven economic policies (also known as Reaganomics) will be presented as a counterfactual to the theory as it had indeed unpredictable consequences by equivalence (what President Trump intends to replicate).

Poterba and Summers [5] published in 1986 a paper focusing the deficit experience lived at that moment, considering it the time par excellence to evaluate the accuracy of the Ricardian Equivalence in practice. Reagan´s presidency took place between 1981 and 1989 and so did the deficit fatten, motivated by ideology rather than economic reasons (previously deficit “obesity” had been observed, though they occurred in war periods). The primary objective of the Economic Recovery Act of 1981 was to boost investment via increased national savings [6], though the Ricardian Equivalence predicted consumers raising their savings rate, perfectly foreseeing a future tax rise, to repay in the future the acquired debt during this period. However, data summed up in Figure 1 shows just the opposite – both the failure of Ricardian Equivalence and Reagan´s prediction – with saving rates lower than in all five-year periods from 1955 (and even with further factors contributing to higher expected saving rates, as increased real interest rates with no positive impact on future income prospects) and consumption levels rising, rather than private investment increasing. The results account for possible cyclical conditions, inflation or stock market behavior impacting the reduction of the national savings, empowering the counter fact to the Ricardian Equivalence.

Sem Título.png

Figure 1 [5]

Rejecting the Ricardian Equivalence in the Reagan period does not destroy its argument. Ricardo and later Barro built the theory under several strong and unrealistic assumptions, hardly verified in the real world, so what is of interest to us is to analyse which conditions failed to hold leading to an impactful deficit based expansionary economic policy.

One relevant assumption in this debate is consumers having an infinite lifetime horizon, not allowing for debt burdens to be shifted to future generations. In practice, this could hold if there can be observed high levels of intergenerational altruism, meaning even though consumers are aware the generation benefiting from tax cut will not be the same paying for it, they value future generations´ wealth as theirs so they save to ease the future burden imposed on the younger generation rather than just maximizing their subjective utility. Despite econometric models from the Reagan period rejecting the hypothesis of this theory holding [7], different papers ([5] and [8]) point to the fact that the crowding out of investment altering national savings in the short-run has little statistical significance hence it is of “secondary importance for judging whether deficits have short-run crowding out effects, even though they are primary determinants of the long-run effects of deficits” [5] .

Secondly, the model assumes perfect foreseeing consumers with no liquidity constraints, meaning the implementation of a lower personal taxes policy should have no impact on consumption. Interestingly, Poterba and Summers [5] found evidence of households having borrowing constraints due to imperfections in the financial market, since once the tax cuts took place, consumption increased indicating consumers used the tax decrease as a form of credit. The authors also highlight two stages Reagan´s tax policy went through and that allow for the distinction of different effects: the advanced announcement of the new policy and its gradual implementation. The results display room for consumer myopia (a term used to describe some difficulty in foreseeing the economic future) as earlier announcements of tax policy were statistically insignificant for consumption changes but its actual implementation was not (if consumers understood the future implications of the announced policies, significantly statistics would show an immediate negative (positive) reaction in consumption (savings)).

The equivalence is established between lump-sum taxes and bond financing, unfaltering agents´ economic choices. However, in real life, taxes are typically a proportion of income, granting them a distortionary character, i.e. an intertemporal substitution effect is induced by which an agent, under (quasi) perfect foresight, may “decide” to work more in the lower marginal taxation period since the higher the marginal tax rate (the lower the marginal benefit of each hour worked) to compensate for a future tax rate increase and by then employ more of his hours in leisure (this trade-off option does not exist with lump-sum taxation) [9]. Having said this, leisure becomes more expensive in the first period, while consumption becomes cheaper (in concordance with the data found following the ERA of 1981)

It could even be discussed the highly demanding assumption of the model of complete markets economies in which there is no government default and debt restructuring options, resulting in unlimited credit and enabling the government to use debt as an instrument to smooth shocks. However, this does seem the most relevant point to the discussion since governments do not have to pay back their debt in the same way as families do, as they can keep on growing debt if their tax base grows faster as a means of committing to their investors. In particular, U.S.´s gross public debt keeps on growing each year and though it is not a truly complete market economy (there is a very tiny option of even the U.S. government defaulting, for example), it is one of the few world market economies with barely no difficulty in obtaining credit and hence use it as an instrument to smooth shocks.

Therefore, if we had to pin point the assumptions that most contributed to the Ricardian Equivalence failure during President Reagan´s supply side policies, the most likely candidates would be perfect foreseeing consumers with no liquidity constraints and lump-sum taxation, though it is not possible to guarantee these results, to ignore the contribution of the failure of other assumptions and to exclude the possibility of a joint effect of different variables (as some authors seem inclined to). In light of President Trump´s statement “My tax cut is the biggest since Ronald Reagan”, what should interest economic policy makers is whether U.S.´s modern conditions will allow for a savings rate increase as a result of tax cutting, and if so, how will the economic distribution vary, i.e. will savings change shift to consumption as in Reagan´s period, requiring the country to attract foreign capital flows to sustain high levels of indebtedness that will not translate into economic investment? Or will President Trump´s administration be able to give the right incentives so that the shift goes to American consumption but also and significantly to internal investment?

Margarida Castro Rego, 23848



[1]Krugman, P. (2009, September 05). How Did Economists Get It So Wrong? Retrieved from

[2]Amadeo, K. (n.d.). What Has Obama Done? 13 Significant Accomplishments. Retrieved from

[3]Scoffield, H. (2017, March 26). THE RICARDIAN EQUIVALENCE. Retrieved from

[4]How your tax bracket could change under Trump’s tax plan, in two charts. Retrieved from

[5]M., P. J., & H., S. L. (1986). Finite Lifetimes and the Crowding Out Effects of Budget Deficits. Retrieved from

[6]Summers, L., Carroll, C., & Blinder, A. S. (1987). Why is U.S. National Saving so Low? Brookings Papers on Economic Activity, 1987(2), 607. Retrieved from

[7]The Economics of Public Debt Proceedings of a Conference Held by the International Economic Association at Stanford, California. (2014). Palgrave Macmillan. Retrieved from

[8]Leiderman, L., & Blejer, M. I. (1988). Modeling and Testing Ricardian Equivalence: A Survey. Staff Papers – International Monetary Fund, 35(1), 1. Retrieved from

[9] Seater, J. J. (1993). Ricardian Equivalence. Journal of Economic Literature, 31(1). Retrieved from


What happened to economic growth in Angola? The problem of currency depreciation and oil exports

The currency crisis in Angola
Without proper care with currency confidence by the Central Bank of a country, the poorest are the ones who will suffer the most, being sometimes blamed without no fault of their own for black market sales of the currencies. Discretionary policies or rules are always a matter of debate in Central Banks not only on developing countries, but also on the developed ones. While the ECB tries to follow specific rules, tying their hands and committing to inflation levels, creating stability and confidence in the currency, for developing countries with untrustworthy financial institutions, discretionary policy may sometimes be the best solution.
In a recent past, emerging economies such as Argentina and Thailand (among others East-Asian and South American countries) have suffered due to a currency crisis that stroke the countries between 1997 and 2002. Currently, countries such as Venezuela and Angola are suffering similar problems (both due to a great dependence of oil exports).

What is going on?
Right now, there is a currency crisis in the Angolan kwanza. Since April 2016, the sub-saharan african country has been keeping constant an official rate of roughly 165 kwanzas per  dollar (usd). The problem is that the official exchange rate is not the equilibrium one. This means that taking into account the currency volatility, confidence level, and purchasing power, people generally value 1 dollar more than 165 kwanzas. In other words, there is a black market in which the currency sells for a higher price. The commonly known “kinguilas”, the name given to dollar sellers in the streets of Luanda, trade kwanzas to dollars at a higher rate. In an NPR (national public radio in the US) interview, one of the so called kinguilas says that she could trade four dollars for one thousand kwanzas[1]. This would translate into an exchange rate of 250 kwanzas per dollar. One may ask “why would anyone want to trade 250 kwanzas for 1 dollar in the black market, when the official rate that one can trade is a cheaper 165 kwanzas per 1 dollar in a bank?” The problem is that the official rate is not equal to the equilibrium one, since there are simply no dollars in the country for the trade to be made at the official rate. The country would run out of dolares, and so the government keeps most of the reserves, without too much being available to the public and to the banks[1]. The problem is the lacking of foreign reserves (dollars).

Why is that a problem?- The purchasing power of the population
The problem for Angola of not having the backing of dollars and no confidence in their currency, is that their consumption goods are almost all imported. With their currency crisis, it is very difficult for them to import goods from abroad, since their dollar reserves are too low, and the kwanzas are not worth much. Angola imports several basic goods from abroad, such as food, medicine, construction materials, vehicles, and capital goods[2], and thus it affects greatly the investment of the rich, and the consumption patterns of the poor that are the most affected party.
Moreover, emigrants in Angola in order to send unilateral transfers to their families have a problem of receiving their salary in kwanzas, and not being able to trade them for dollars. People have to “get creative” to deal with this problem, by buying assets that have intrinsic value such as cars, shipping them to a country with a stronger currency, (euros or dollars for example), and trading the goods for the currency[3]. For low earners and poor people, the scenario gets even darker as they move to their nearby countries, such as Congo, to sell products in order to get their hands on dollars.

What can be done to solve the problem?- The real exchange rate

The real exchange rate represents the purchasing power of the Angolan consumers to goods sold abroad, and it is primordial for Angola to protect it considering its huge dependence on imports.
The real exchange rate depends on three things: the nominal exchange rate, the price level index of foreign goods and services (in dollars), and the kwanzas price level index. To control the real exchange rate, Angola has some control over the nominal exchange rate (in a confidence providing aspect), and has control over its own inflation.
Angola’s Central Bank has two options as any other Central Bank of a developing country with uncredible institutions and weak currencies.The first option is to  peg its currency against a strong one, such as the dollar, which is being done from April 2016 as it was stated earlier.  The main advantages of this policy is to protect a real exchange rate devaluation in the long-run, by increasing confidence on the rule following policy of the Central Bank. How can Angola keep the real exchange rate fixed? Assuming a stable nominal exchange rate, which happens when a currency is strong and have the investor’s confidence, Angola would just have to increase their price levels proportionally to the dollar price levels. This is what is called pegging against the dollar. The problem is that Angola does not totally control for the nominal exchange rate. Although commitment to pegging can increase the investors confidence and thus holding stable the nominal exchange rate, the nominal exchange rate can be driven by speculatory movements when there is no confidence in the financial institutions, mainly the Central Bank, to keep the peg. Thus, the more investors bet on the peg to break, the more likely it will happen. This is what is called a self-fulfilling currency crisis and it has happened in Argentina. By pegging to the dollar, Angola is protecting consumer prices, at the risk of the peg not holding (which is actually happening as there is a black market in the currency trade, as the dollars are more scarce than what the government tries to state they are). The low levels of foreign reserves makes investors not believing in the peg. It’s all a matter of confidence.
The second option is to let the exchange rate float. The main advantage of this policy in the short-term for Angola is that it could guarantee that the real exchange rate would be kept fixed. The problem of this is that it would not be sustainable in the long-run. As expectations adjust, the nominal exchange rate would be more and more depreciated (as people expect for the currency to be devalued throughout time), which would force the inflation to increase further and further in order to keep the real exchange rate fixed. This could lead to hyperinflation, and with such a high instability in the currency value this would definitely not be the best solution. Cases of recent hyperinflation in Zimbabwe led to catastrophic economical and social problems, with the highest monthly inflation rate accounting to 79,600,000,000%, as the currency depreciated to a value of (roughly) zero [4].

How did Angola got to that situation?

Mainly because of its oil dependence. According to OPEC, oil production and related activities account for 45% of the country’s’ GDP, and 95% of their exports[5]. The drop in oil prices in recent years (from 2014 onwards) has been cut down by half, from roughly 100$ a barrel to 50$ a barrel (being closer to 60$ this month). The problem with this is that the main source of dollars the country had began to provide fewer, and fewer dollars. The 27.7 billion dollars backing the kwanza in 2014 were roughly halved to a value of 15.4 billion dollars in October 2017, according to the National Bank of Angola (Graph 1). Without backing, and poor economic results due to the decline in oil prices, the currency loses the so needed confidence to keep the nominal exchange rate stable.

A new hope
Angola’s new president João Lourenço has promised to do some restructuration of key sectors, that were tightly controlled by the familiy of the former president José Eduardo Dos Santos, and the richest woman in Africa, Isabel Dos Santos. He has already taken actions by hiring a new chairman to the state owned oil company Sonangol, taking the control away from Isabel dos Santos. It has also appointed a new president for the National Bank of Angola (José Massano). However, the presidency is yet to fresh for results to be seen. For now, Moody’s has even downgraded Angola’s credit rating, arguing that their their foreign reserves levels were low, high inflation (26% in November) in the country persists, there is low public spending , and that the banking system is weak[6]. There is still much to be done, but for now, the new president has shown some character in trying to disentangle the tight control of the family over the government and thus increasing confidence in the country’s Central Bank and on their oil production firms, the main problems affecting the currency devaluation in Angola in the last years.

Graph 1
Sem Título



Eduardo Carvalhos Dos Santos
Student number 4187

Liquidity Trap, Monetary policy and Fiscal Policy

  1. Liquidity Trap

The term liquidity trap was initially proposed by John Maynard Keynes in 1936. Several researchers and economists doubted about the practical application of this concept for many years. However, central banks turn out to be concerned with this phenomenon when the liquidity trap became a reality in some countries. The two main examples of liquidity traps happened in the Great Depression in the United States during the 1930s and in the Japan economic slump during the late 1990s.


  1. Ineffectiveness of Conventional Monetary Policy

Economists such as Paul Krugman and Ben Bernanke highlighted and discussed this subject and its enormous macroeconomic implications several times. Paul Krugman (1998) defined the liquidity trap as a situation in which monetary policy loses its effectiveness to stimulate economic growth because the nominal interest rate is nearly zero. When this happens, the opportunity cost of holding money becomes nil and even when the Central Bank increases the money supply to stimulate the economy, the economic agents will continue to accumulate money instead of investing it. Since the nominal interest rate cannot go below zero, we came to a situation in which the efforts of the monetary policy are ineffective. Moreover, one consequence of the liquidity trap is deflation. And, if deflation persists for a long period, individuals would expect negative inflation to continue.  Consequently, the real interest rate – which is defined as the nominal interest rate without expected inflation – will increase. This, in turn, harms private investment through increased real cost of borrowing and thus widens the output gap. And then the economy is in a vicious cycle of output stagnation.

Oliver Blanchard and David Johnson (2013) believe that the way to avoid an economy to get into a liquidity trap is by set higher average inflation. The higher the average nominal interest rate, more options the central bank has to decrease the nominal interest rate when a shock happens.
According to Paul Krugman and Robin Wells (2009), Japan experienced a significant increase in the prices of both stocks and real estate during the late 1980s. This resulted in a long period of economic stagnation – the Lost Decade.

During the 1990’s, Japan found itself in a liquidity trap when its long-term interest rates were almost at zero and short-term interest rates reached zero, which make impossible for the Japanese central bank to decrease even more the interest rate. The economic growth in Japan was almost nil and the prices were decreasing systematically. (Eggertsson and Woodfor 2004). The Japanese economy has stagnated for a long period and the Japanese governments used monetary and fiscal policy to try to solve this macroeconomic issue (Goyal and McKinnon 2003). According to Paul Krugman (2000), the bank of Japan found itself in a situation in which he could not increase demand. By 1988 interest rates in Japan were almost at the zero lower bound and monetary policies were not a solution anymore.
In an attempt to drive the economy to continuous growth, the bank of Japan responded by cutting interest rates until their limit.
A prolonged economic slump in Japan led to deflation from the late 1990s on. Deflation in Japan (-0.2 percent) was not so strong compared with the Great Depression case in which the inflation rate was around -6.7 percent. However, it persisted during a long period, from 1995 to 2005.  Deflation is likely to cause failures in the financial system which may, in turn, intensify a liquidity trap since the unpredicted deflation raises the real debt value.

  3. Solution for the Liquidity Trap

3.1. Fiscal Policy

When the effectiveness of monetary policy fails to boost the economy, it is imperative to search for other alternatives.
The classic Keynesian answer to the liquidity trap is expansionary fiscal policy. During recession periods, private saving tends to increase fast. Hence, expansionary fiscal policy helps to offset this increase in private sector saving and injects money into the circular flow.
Since expansionary fiscal policy has positive effects on output and investment, governments can create government spending policies to raise aggregate demand.
The Japanese government started an enormous expansionary fiscal policy during the 1930s. Several economists agree that this government spending was crucial; however, this measure was not enough to lead the economy to substantial growth and the Japanese economy remained depressed for a long time.
In the case of the Great Depression, the US government slightly increased deficit spending during the 1930s. Some years after, with the entry of US in the World War II, deficit spending increased dramatically, and it ended up the Great Depression.
The question that arises is how effective can be the use of fiscal policy in a liquidity trap.
An expansionary fiscal policy may lead to an increase in the size of a government’s budget deficit. This could lead markets to fear debt default and push up interest rates on government debt.
Paul Krugman (2000) believes this increase in government expenditures may conduce to a situation of high government debt when the interest rate becomes positive again.
Several researchers have recently highlighted the financing consequences of fiscal policy.
The literature seems to agree that fiscal spending needs to be provisional and combined with procedures that guarantee fiscal sustainability. This will preserve trust in the sustainability of public finances and support both the recovery and long-term economic growth.


3.2. Unconventional Monetary Policy: Quantitative Easing

In 2001 the Bank of Japan executed the quantitative easing policy and it was implemented again during the Great Recession in 2009 and afterward. Quantitative easing is one of the most used unconventional monetary tools to give response to the liquidity trap. It consists of purchases by central bank of long-term government bonds to decrease long-term interest rates, increase money supply and raise economic activity (Krishnamurthy and Vissing-Jorgensen 2011). The process is quite simple: Central banks buy government bonds with money created electronically and use it to purchase bonds from investors. This, in turn, will lead to an increase in the number of funds in the financial system. As the amount of money in circulation in the economy rises, financial institutions have the possibility to lend more. It can also drive down the interest rates even if they were almost reaching their limit level. This may lead to a situation where consumers and investors spend more, enhancing the economy.
The effectiveness of unconventional monetary tools seems to be a discussion that does not reach overall agreement.
While some economists believe that unconventional monetary policies tools can help in recession times, others defend that this method is not as reliable as conventional monetary policy.

To sum up, I believe this subject deserves political and economic concern since it occurred in the most powerful economies of the world and its macroeconomic implications are enormous.
It is important to find economic and political solutions to prevent economies to get in a liquidity trap and it seems essential to develop new efficient measures to overcome recession periods.





Krugman, Paul (2000) Thinking About the Liquidity Trap. Journal of the Japanese and International Economies

Werning, Ivan (2011) Managing a Liquidity Trap: Monetary and Fiscal Policy. Nber Working Paper Series

Krugman, Paul. (1998). ‘‘It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap.’’ Brookings Papers on Economic Activity.

Krishnamurthy, Arvind and Vissing-Jorgensen, Annette (2011) The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy.

Goyal, Rishi and McKinnon Ronald (2003). Japan’s Negative Risk Premium in Interest Rates: The Liquidity Trap and the Fall in Bank Lending.

Blanchard Oliver and Johnson David (2013) Macroeconomics.

Krugman Paul and Wells Robin (2009) Macroeconomics.


Mariana Bêa 3093


The Below Zero Lower Bound: How low can you go ?

Exceptional times require exceptional policy measures. Despite the economic theory of the lower zero bound, a new era of negative interest rates has emerged. How can central banks break through the zero lower bound ? And if there is no such barrier as the zero lower bound – how negative can rates go ?

In theory, the zero lower bound refers to the situation in which the central bank cannot lower the short-term nominal interest rates because they reach or near zero. In such a scenario the central bank loses its capacity to stimulate the economy and only fiscal policy can have an effect. If the central bank were to lower the interest rate any further, banks would choose to hold physical currency that pays a zero nominal interest rate rather than earn a negative rate of return on deposits held at the central bank. When passed to the customers, negative interest rates trigger account-holders to withdraw their money and hold it in cash. Negative interest rates – in the words of Harvard economist N. Greg Mankiw – “only […] generate […] a demand for safe assets – and by that I mean […] they are going to be buying a bunch of safes so people can put their money in their safes rather than in the bank.”   Ultimately, the entire economy would become a cash-based system because no rational economic agent will hold assets if their rate of return is dominated by another store of value.

However, five currency areas, namely the European Union, Japan, Denmark, Sweden, and Switzerland have adopted negative interest rates since the financial crisis in 2007. In this upside-down world, borrowers get paid, savers penalized and the zero lower bound is not actually binding. How can we make sense of that?


 Negative interest rates. Source: European Central Bank. Graphic available under:

In fact, holding cash is associated with real costs. First, there is the cost of storing money. Particularly for large amounts of cash, agents  need to acquire storage units and establish safety procedures or insurance against loss, damage and theft. Note that one million dollars weight about 100 kilo in 10 $ bills but only 10 kilo in 100 $ bills . Second, paying in cash is often inconvenient, and, third, trips to the bank in order to withdraw cash require time and energy.  As agents are willing to pay to a certain extent for avoiding these costs, the true lower bound is actually some negative number – zero minus the total costs of holding cash. Economists estimate this cost to be in between 0.5 percent and 2 percent of the face value. This is in line with recent data suggesting that interest rates can go as low as negative 0.75 percent without triggering the hoarding mechanism.


We will present three methods to effectively overcome this lower bound by discouraging hoarding of currency: Introducing a tax on base money, abolishing paper currency, and separating the account function of money.


Historical proposals for overcoming the lower bound include SilvioGesell’s tax on base money – that is physical cash and commercial bank’s balances with the central bank. Basically, the tax extends negative rates to physical currency and, thus, eliminates the possibility of evading negative rates by hoarding cash. Since then, the idea of money that depreciates over time has been taken up by various economists including Keynes, Fischer and Goodman.

However, implementing a tax on currency may be too administratively cumbersome. Coins and bills are bearer bonds, i.e. that the identity of the holder remains anonymous to the central bank and the ownership can be transferred by delivery. Therefore, the owners have to reveal themselves in order to pay the taxes. Moreover, it has to be possible to verify whether interest due has been paid. In accordance with the idea of clipping the coupon, Gesell proposed to stamp currency by an expiration date in return for the interest payment. Unstamped currency will not be officially recognised as legal tender and become worthless. An up-todate example of Gesell money is so-called “regional money”, that customers can pay with in certain regions of Germany, e.g. the “Chiemgauer” in Bavaria, which loses 2 percent of its face value every 3 months if it is not stamped.

In 2009, Mankiw suggested a lottery scheme based on serial numbers to randomly declare bank notes void. The central bank would pick a number between 1 and 9 and all notes whose serial numbers ended by that number would become worthless. Thence, holding cash becomes risky and the expected nominal interest rate on cash negative. As a result, the floor on short-term nominal interest rates is pushed further down; rational agents will prefer assets to cash for interest rates above negative 10 percentminus the cost of carrying cash. This provides plenty of scope for negative interest rates.


Some academics such as Rogoff, Yglesias and Buiter have gone even further and suggested abolishing paper currency entirely, thus eliminating the option of hoarding cash in order to avoid paying negative interest rates. In an economy with an ever-growing range of electronic paymentmethods, physical currency will sooner or later become a redundant mean of payment. Europe’s march toward a digital-only economy seems to be unstoppable and can be best illustrated by the increasing number of shops and even banks that do not accept cash anymore. For instance, cash transactions account for less than 2 percent in Sweden.

Nonetheless,many agents demand paper currency for privacy related reasons. While traceable electronic money helps to fight the underground economy, it implies a drastic change in transaction techniques, unlimited government power and dependence on technology.

To ease the transition into a cashless economy and to achieve social acceptance, Rogoff’s proposal includes starting with the removal of high denomination bank notes from circulation and slowly letting small denominations fall toward disuse. In the foreseeable future, Rogoff advocates a low-cash society rather than a cashless society. Recently, the ECB may have taken the first step towards a low-cash society by announcing that itwill no longer produce 500 EUR bills after 2018. While 500 EUR bills are almost never used to carry out legal transactions, they account for roughly a third of the value of euro currency.


Nevertheless, the most important role of money is not its role as a medium of exchange or store of value but as one of account. In 1932, Eisler first suggested decoupling the numéraire function of money by creating a parallel virtual currency. Paper currency would continue to exist, but prices would be set in units of the numeraire currency. The exchange rate between paper and this currency could be used to create a negative interest rate on physical currency. The main challenge and key to success is to ensure that the numeraire does not follow the paper currency. If this were the case, the transition would have the same effect as simply changing the currency (like the transition from DM to EUR). Succesful examples include countries with hyperinflation, where a more stable foreign currency is used as a unit of account.


All three methods of eliminating the lower bound remove the possibility of avoiding negative interest rates through a broad shift into cash. In theory, there is neither a zero nor a below zero lower bound on nominal interest rates and central banks could push rates into negative territory. However, there is a lack of consensus on the use and effectiveness of negative interest rates and it remains to be seen whether they should be considered a blessing or a curse for the economy, banks and consumers.




Agarwal, R. and Kimball, M. (2015). Breaking through the Zero Lower Bound.  IMF Working Paper. WP/15/224.

Bartholomew, L. (2016). How muchmore negative can interest rates go?  TheStar.

Blanke, Jennifer and Krogstrup, Signe. (2016). Negative interest rates: absolutely everything you need to know.  World Economic Forum.

Buiter, W. H. (2009). Negative nominal interest rates: Three ways to overcome the zero lower bound.  The North American Journal of Economics and Finance, 20(3), 213-238.

Buiter, W. H. (2005). Overcoming the zero bound on nominal interest rates: Gesellâ˘A ´ Zs currency carry tax vs. Eisler’s parallel virtual currency.  International economics and economic policy, 2(2-3), 189-200.

Buiter, W. H., and Panigirtzoglou, N. (2003). Overcoming the zero bound on nominal interest rates with negative interest on currency: Gesell’s solution.  The Economic Journal, 113(490), 723-746.

Davies, G. (2015). How negative can interest rates go?  Financial Times.

Kimball, M. (2012). Howpaper currency is holding theUS recovery back.  Quartz. Available under:

Goodfriend, M. (2000) Overcoming the Zero Bound on Interest Rate Policy.

Heller, N. (2016). Cashing Out.  The New Yorker, October 2016.

Henley, G. (2016). Sweden leads the race to become cashless society . The Guardian. Available under:

Irwin, Neil. (2014). Europe Gets Negative Interest Rates. What Does That Even Mean?.  New York Times.

Lauer, J. (2011). Noch so ein Schwundgeld.  Frankfurter Allgemeine. Available under:

Mankiw,G. (2009). It May Be Time for the Fed to Go Negative.  New York Times.

Nasir, M. A. (2016). Zero Lower Bound and Negative Interest Rates: Choices for Monetary Policy.

Rogoff, K. (2014). Costs and benefits to phasing out paper currency . Harvard. NBER Macroeconomics Annual Conference.

Shastri, R. (2010). Beyond the zero lower bound on nominal interest rates. Available under:

How the Zero Lower Bound affected Quantitative Easing

In the past years, a lot has change when we talk about monetary policy. After the financial crisis, European countries face unconventional instruments used by European Central Bank (ECB) in order to conduct the monetary policy of the European System and with the goal of stabilize the economies. And then, when the interest rates start to get negative values, the ECB have seen these policies become unpopular.

One of that instruments after crisis was the well-known Quantitative Easing. This instrument consists in purchases of government securities or other securities from the market by the ECB. This purchase will lead to decreases in the interest rates and increases in the money supply to encourage economic growth.

At this time, Economists believed that the interest rate cannot go below 0. So, when the actions of Central Bank lead to interest rate near zero, it will not go lower. But a question is generated: can quantitative easing still have effects at the Zero Lower Bound?

When we have the interest rate at the level of zero lower bound, the economy is in a liquidity trap, this means that any inflation or deflation are built based of expectations. To understand the role of expectations it is important that we review the concept of “Taylor rule”.

According to Taylor, the short-term interest rate is function of the interest rate that the CB wants to define (r), inflation (  and expectations about the level of inflation and the level of employment/output (Q). The capacity of CB to set the interest rate will increase if the agents believe in the CB intentions, i.e., the parameter  will match  and  will match  and the interest rate will be totally determined by inflation and real interest rate (chosen by CB).

When the Central Bank increases the money supply (Quantitative Easing), it is important that this action affects the future money supply because this is the variable that provide real effects. This permanent increase in money supply will lead to increase in prices and wages in the same proportion. So, if quantitative easing is expected to be reserved, it may have no effects on prices and then no effects on output as well.

So, if Quantitative Easing is credible over time, it will have real effects in the short-run even at the zero lower bound. This will be reflected in higher inflation expectations and lower interest rates, so in order to achieve effects with Quantitative Easing at the zero lower bound it is important to monitoring the developments in inflation expectations and policy-makers must find alternatives to keep the long-term inflation expectations credible.

However, this position was defended before some countries face a negative interest rate. All the arguments above were made assuming that the interest rate will not fall below 0, because facing negative interest rates people will prefer to hold money than buy bonds. The lower bound for interest rates is not zero anymore however economists like Tony Yates, Professor in University of Birmingham, are saying that the “zero lower bound” components are still there, just modified slightly by the costs of storing cash.

The purchases of sovereign debt have led to a decrease in the returns of bonds. This bond had become less attractive to investors and they move into riskier investments. Because the demand for bonds, when the interest rates were close to zero, was higher than the equilibrium, the interest achieved a negative value.

In the last year one problem has raised: how will the Central Bank react to the negative interest rates? Is this the end of the ECB dominance?

The first bank in the world to pass to the customers negative interest rates was Alternative Bank Schweiz (ABS) and other banks around the world, like Swiss National Bank (SNB) follow this behavior. This seems to be the latest weapon of central banks, in an attempt to support economic growth and inflation.

This happened because the Central Banks have run out of room to cut interest rates above zero and their quantitative easing schemes have become unpopular, so they had to present solutions. This negative interest rates should, in theory, boost the economy because forcing people to pay for have their money in the bank will lead to increase investment or consume.

However, negative rates are not achieving this boost in the economy, instead this interest rates are being seen as a sign that central banks have nothing left to solve the weak demand problem. In the last years, the fiscal policy has reduced its size and the monetary policy is the ultimate responsible to support economic demand.

Because buying sovereign debt is not working, one obvious place to go is buying corporate debt. However, if QE became unpopular, buying debt of largest companies will be even more so.

The goal of QE was to, with the increase in demand for government bonds, the interest rate will decrease and will be more attractive to investors and then inspire them to increase their demand for other investments which will boost the economy. But this effort to stimulate the economies faced a problem, the debt of the Eurozone is not consolidated and so ECB must buy bonds of the member states, in different quantities.

The Eurozone crisis of 2010-2011 brings the possibility of Eurozone break up and if this occurred it is better to own debt of a stable country like German than debt of a country like Portugal. Whatever the interest rate on Portugal bonds, the rate on German bonds is sure to be lower.

So, these negatives interest rates are a way to rescue these policies focused on interest rates. But there are limits on how far the negative rates can go. If it gets too steep, banks have an obvious alternative: get physical money and store it.

However, some solutions to make the negative interest rates more feasible start to appear. If the ECB or the Federal Reserve decides to raise its inflation targets, inflation-adjusted rates can go lower. However, the effectiveness of the current targeting regime wouldn’t be that high, and thus we’ll new to find a new framework to conduct the monetary policy.

The role of negative interest rates is very unknown because is a phenomenon too recent to check for effectiveness. We can affirm that this is the approach that the ECB is trying to explore and it have to overcome a few barriers in order to achieve the proposed results.

Ana Marques (3710)













[1] Evan F. Koening, Robert Leeson, George A. Kahn.The Taylor rule and the Transformation of Monetary Policy

[2] 2016, Peter Spence. How negative interest rates marked the end of central bank dominance. Available at

[3] 2015, Matthew Yglesias. Something economists thought was impossible is happening in Europe. Available at

[4] 2016, Gail D. Fosler, Josh Tom. Are Negative Interest Rates and Quantitative Easing Compatible? An Interview with Christian Noyer. Available at



Way out of a crisis – Analysis of the case of Iceland

Background – primary reasons of the crisis 

2008 was a landmark in Iceland from the point of view of the entire economy. The unprecedented scale of the financial crisis turned into a deep economic recession and forced the government to make major changes in the area of fiscal and monetary policy. What where the primary causes of the crisis in Iceland ? What made Iceland so particularly vulnerable to the consequences of the financial crisis that begun in United States and expanded globally ?
The factors that led to this situation can be found already in the 90s and 2000s, a period of deep free-market reforms aimed at making Iceland a wealthy country that would be among the most developed countries in the world, both in terms of economic freedom, quality of social care and general level of earnings.

The reforms led by prime minister David Oddson were mostly liberal and covered almost all sectors of the economy. Although contributed to a very large extent to the growth of the society’s prosperity and competitive advantage, they were not free of mistakes. The main mistakes that affected Iceland’s vulnerability to the crisis were three things:

1) Too loose monetary policy combined with an expansive fiscal policy. In the years 2001-2007, with the exception of 2003, interest rates were always set well below the values recommended by the Taylor rule. In conjunction with a fiscal system oriented on large expenditures and tax cuts, the pursued monetary policy overheated the economy.

2) Inadequate financial supervision. The Icelandic supervising office (FME) tried to regulate banks before the financial crisis, but they lacked sufficient experience and qualified staff. The most competent employees of the financial supervision office were often employed by dynamically developing banks.

3) Government support for the state Housing Financing Fund, which in the case of Iceland turned out to be unfair competition from the state to the banking sector. Thanks to state guarantees, HFF was able to provide loans that are not comparatively cheap in relation to loans granted by private banks, which in such a small market as Icelandic economy pushed the banking sector to expand abroad and to compete more in order to survive. In search of cheaper financing of their lending, private banks turned to the countries of the euro zone. In addition to the above-mentioned concern, a major mistake on the part of HFF was lowering standards for granting mortgage loans – HFF loans were many times given to people who did not meet the creditworthiness criteria according to private banks.

As a result of the last-mentioned factor, many Icelandic foreign branches were created, based on the so-called “single bank passport” (and here it is worth to highlight particularly the branch of the Landsbanki bank – Icesave, which attracted large amounts of deposits from Great Britain and the Netherlands with high interest rates). When the availability of financing on the European debt securities markets was limited (due to the increasing concern of foreign rating agencies about the ratio of the Icelandic banks’ debt to their reserves), banks became more involved in US markets, securing their debt securities with CDO instruments. The excessive dependence on foreign financing and the low level of own reserves meant that Iceland became extremely vulnerable to the global decline in liquidity, which appeared with the crisis in the United States. 
In October 2008, the European Central Bank asked Landsbanki to increase reserves by EUR 400 million. This call, although it was cancelled, resulted in a run to Icelandic banks in the UK. The outbreak of banking panic forced Landsbanki to ask for financing assistance to the central bank. Once its application was rejected, the domino of bankruptcy of Icelandic banks started.

Recovery program – design

Designed by Icelandic economists and accepted by IMF recovery program, aimed to reach 3 main goals:
– elimination of negative consequences of financial crisis through stabilizing the exchange rate,
– development of comprehensive and sound strategy for restructuring of the banking system,
– realization of long-term program of fiscal consolidation and mitigation of the impact of losses incurred by bankrupt banks on the financial condition of Icelandic economy.

To achieve first goal – it means stabilization of the exchange rate, apart from conventional methods such as intervention on the currency market and regulating interest rates, the Icelandic government decided to introduce temporary capital controls, effective from November 28, 2008.
The reason behind introducing such a radical solution was the fear that due to the scale the crisis and the size of the financial market in Iceland, the first two methods mentioned would be too costly, and at the same time they did not guarantee enough sufficiency and effectiveness. In that case interest rates would have to be significantly increased, and intervention on the currency market would be associated with a marked deterioration of the Central Bank’s foreign exchange reserves.
The introduction of capital restrictions including both the inflow and the outflow of capital from Iceland, especially during the period of widespread panic, gave entrepreneurs and the state time to restructure their own finances, regain control over them, calm down moods and revive the economy.

Focusing attention in 2008 on the stabilization of the Icelandic national currency was treated also as a key strategy element in leading to a reduction of inflation to the level of the inflation target. It was kind of a throwback to the monetary strategy of Iceland in the nineties, when the main goal of the Central Bank was primarily to control the course of the Icelandic krona, and only then the inflation target.

Actions taken by the central bank regarding the exchange rate refer to the trilemma of monetary policy resulting from the Mundell-Fleming macroeconomic model. The mentioned relationship indicates that it is impossible to maintain a fixed exchange rate, free capital flows and sovereign monetary policy at the same time. By opting for the chosen two of the three objectives, the state involuntarily loses the ability to achieve the third. Setting interest rates at a lower level than in foreign markets with a free capital flow puts pressure on the depreciation of the currency, because investors attracted by the possibility of a higher profit transfer their capital to foreign markets. In order to maintain a constant exchange rate, the bank would be forced to sell foreign currency reserves. The domestic currency would ultimately depreciate because the reserves are limited.

Most countries in the world are currently choosing the option of free movement of capital with the maintenance of a sovereign monetary policy. The exception are states in monetary unions, for example, countries belonging to the euro area, which excludes the possibility of independent monetary policy management. After the 2008 crisis, Iceland chose the third way – maintaining a stable exchange rate and the ability to conduct its own monetary policy at the expense of free capital flows.

In other areas of monetary policy, Iceland has become decidedly restrictive. Interest rates increased from 11% in November to 17.5% in December 2008 and were consistently maintained at a high level until February 2011, when after a series of gradual reductions reached 3.5%.
Icesave, a deposit belonging to the Landsbanki bank, was also refused. After the negative results of the referenda, the Icelandic government did not accept any responsibility for the debts of private banks and Icesave deposits in the period I was investigating were not covered by Iceland. This decision had both a positive and a negative impact on Iceland’s economy. Iceland lost the credibility of a safe place when it comes to investing capital, but at the same time taxpayers were not burdened with additional debt resulting from the improper policy of private banks.

The adopted program and its implementation contributed to the rapid rehabilitation of the Icelandic economy.

Immediate steps taken to restructure the banking sector and private sector debt were key to getting out of the recession. An important item in the budget policy was obtaining additional financing from the IMF, the Scandinavian countries and Poland, thanks to which the afore-mentioned shares could be financed. Thanks to the gradual and carefully conducted fiscal consolidation, Iceland again began to record budget surpluses. These surpluses and improving macroeconomic indicators contributed to rebuilding the confidence and image of Iceland in the international arena, which enabled the release of government bonds in 2011 to USD 1bn to obtain further financing. Iceland was able to pay off its debts ahead of time. Worth noticing is the fact that at the time of the crisis, Iceland’s debt was a private debt, not a state debt, and that Iceland had its own currency. Thanks to the fact that in the years of prosperity, the Icelandic government allocated budgetary surpluses to pay off its own debt, at the time of the crisis he was prepared for active assistance in eliminating private debt. It was different in the case of Greece, which at the time of the crisis had a huge public debt and at the moment the state could not – like Iceland – take over the private debt. Owing to the maintenance of its own currency, at the moment of a sharp depreciation of the Icelandic krona, the Icelandic products became more competitive, a great stimulus to exports, leading to increased revenues for Icelandic enterprises.

Zofia Senatorska



International Monetary Fund, Iceland: Request for Stand-By Arrangement: Staff Report; Staff Supplement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Iceland, (access: 04.12.2017), s. 79 .
The Central Bank of Iceland, Capital controls and their role in the economic recovery, (04.12.2017).
Factsheet, Iceland’s Economic Recovery Programme, Ministry for Foreign Affairs of Iceland, 2010, (dostęp:28.09.2017). Continue reading

Analysis of Economic Crisis in Latin America

Latin America has been the centre of several economic and financial crisis over the last four decades. These systematic events reveal that this continent is subject to some degree of instability, making it interesting from the macroeconomic perspective. Adding to the global recession in 2008, there were two main economic crisis in Latin America: the first one in the beginning of the 1980s and the second one in the late 1990s until around 2002.

This article aims at describing and understanding such phenomenona in this region of the globe, particularly because Brazil has been experiencing an economic crisis, since 2014, mainly due to the corruption and political instability which has a direct influence in the economic situation of the country. According to the World Bank, the unemployment rates are increasing, there are high credit costs and the growth perspectives of the country are among the lowest in the continent which make the Brazilian economy “the worst in Latin America”.

One interesting characteristic of the economic crisis is that they are preceded by a boom phase in which the expectations of individuals about the future are optimistic and, consequently there is an increase in capital inflows for the country. Latin American countries are not an exception of this rule and have experienced this phase several times in recent years. However, after the excessive amount of inflows from abroad, a sudden stop might occur. An alternative way of defining sudden stop is to name it a phenomenon in which an abrupt decrease of net flows from abroad to a given country occur.

Sudden stops are more common in Latin America or emerging economies, than in Europe or other developed economy. From this statement arises one important outcome that help us understand the volatile reality of Latin American economies: due to its instability, public and private sector usually agree short-term repayments of debt. Reinhart and Calvo (2000) state the importance of being extremely careful with the current account deficits (a consequence of sudden stop), especially if financed by short-term debt.

As previously referred, the occurrence of a sudden stop is likely to have a negative effect in the current account, impacting in the short-run both employment and production. Despite the impact in current account deficit, the fragility of the economies in this region need to be careful addressed, as sudden stops can increase the financial vulnerability of a specific country if along with the current account deficit, the same country also faces a huge decline in its international reserves. Ultimately, sudden stops will lead to negative outcomes (even recessions) as consumption and investment are likely to decrease and the policies available are restricted by capital controls.

By the time the international capital markets were developed, Latin American countries were among the nations that were part of such community. Starting with Brazil, these nations started to accumulate external debt, first by public authorities and later by private ones. It is widely recognized that the existence of capital markets is important for borrowers and investors: the international capital market allows borrowers to have more supply of funds/money and to lower the cost of capital, while for investors it allows them to have more alternatives to invest, enabling them to build portfolios that allow for a diversification of risks. Being part of the international community benefits Latin American countries by enabling investors to build portfolios with these countries’ risks.

If it’s true that South American countries started receiving large amounts of funds from abroad, it is also true that this region faced a large number of financial crisis. As countries open for international market, the domestic interest rate tends to increase and early investors try to take advantage of any differences between domestic and international rates. As the first movers have benefits, other agents try to exploit such benefits. The increasing amount of capital flowing to the economy decreases then the domestic interest rate, expanding both production and employment. Consequently prices tend to increase and there is a pressure for the exchange rate to appreciate and for the trade balance to become weaker.

The reduction of trade balance value is the downturn of countries’ positive situation, as such decrease leads to an increase in interest and current account deficit. The decrease of trade balance value ultimately alters the credibility of exchange rate, making it doubtful (exchange rate depreciates) and, as agent perceive this phenomenon, the capital inflows will decrease. At such stage the national authorities are forced to increase the interest rate, but at some point this option is no longer attractive and will, ultimately, lead to an abrupt decrease/stop in inflows.

The first sudden stop in Latin America countries occurred in the early 1980s, as previously mentioned. Affected countries tried to deal with this problem by nationalizing some private sector external debts and to negotiate the debt payments with international financial institutions and commercial banks. After these agreements were met, countries were able to grow again at low rate and experienced high and increasing inflation.

After the first sudden stop and through the first half of the 1990s decade, Latin American countries experienced a considerable growth, undermining the possibility of occurrence of another crisis (which would occur from around 1995 to 2002). The second sudden stop occurred after crisis in Asian countries in 1997, but more importantly after Russian crisis in 1998. Several authors, such as Calvo and Talvi (2005), analysed such impact and tried to infer some explanations of Russian influence for Latin America’s sudden stop and further crisis. As both regions were part of the so-called emerging economies, after Russian default, the investors of this type of countries faced great losses and a liquidity crisis and, in order to meet their desired margins, were forced to quickly sell their emerging market bonds. Alternative explanations of these two sides’ relations could be drawn as, for instance, after the IMF refusal to bailout the Russians, investors could become more cautious about the emerging markets, fearing the high risks for such investments.

Suspicions about emerging markets increased and triggered the occurrence of the second sudden stop in Latin America by the end of the Millennium. This second sudden stop would have a stronger impact due to the financial obligations countries were still meeting from the first crisis.

One important conclusion to take after this second sudden stop is that several countries were hit differently, as domestic fragilities associated with the sharp decrease of capital flows, could deepen such external effect. In Chile, despite the sudden stop and economic crisis, the negative outcomes were not as strong as in Brazil (which would face a currency crisis) or Argentina (which would end up defaulting on its debt and devalue its currency).

Important explanations for this domestic differences effects can be related with how open the economy is and the impact currency’s devaluation: the change in exchange rate to accommodate Sudden Stops is larger for closed rather than open economies. For instance, the impact in Chile was not as strong as for Argentina or Brazil, as this country had a more open economy at the time. An interesting point to add in this context is that countries tried to establish stabilizations policies previous to the crisis with the creation of an almost fixed exchange rate. However the outcomes of such measures were not positive, as for Brazil it lead to an exchange rate crisis, and for countries like Argentina and Uruguay it lead to financial and external debt crisis, devaluation of currencies and banking and currency crisis.

As there are some evidence that Brazil can be heading to a not so bright future, than some conclusions are possible to draw from the policy perspective either before or after the sudden stop emergence. It is important to state that in the boom phase monetary policy and comprehensive regulation are upmost priorities if also aligned with macroeconomic cautions, such as exchange rate policy (that reduce speculation) and balance of payment management. Capital controls are not the best solution, but due to the incapacity of emerging economies to deal with floating exchange rates they may be an option for such countries. Lastly, after the crisis both fiscal policies and interest rate policies can be part of the solution, however its use must be very cautious as many possible drawbacks for the population can occur if such instruments are not properly applied.

Miguel Madeira, 3117


Calvo, G; Talvi, E, “Sudden Stop, Financial Factors and Economic Collapse in Latin America: learning from Argentina and Chile”, 2005, NBER

Damill, M; Frenkel, R; Rapetti, M, “Financial and currency crises in Latin America”,

Reinhart, C; Calvo, G, “When Capital Inflows Come to a Sudden Stop: Consequences and Policy Options”, 2000, MRPA

Rapozza, K; “World Bank: Brazil Is The Worst Economy In Latin America”,2017, Forbes

The story behind the Portuguese trade (im)balance

expressoIllustration taken from the Expresso newspaper

The 90’s were exciting times for the Portuguese Economy. GDP was growing rapidly, unemployment was low and the promise of Portugal converging to European standards was becoming more and more a reality. In parallel, a problem began to emerge: external deficits started to accumulate year after year creating a huge external imbalance.  Trade deficits were systematically negative in the late 1990s and in the first decade of the 21st century (fig.1). In this essay, I will try to discuss the origins of the external imbalances of the Portuguese economy as well as its evolution in the last two decades.

Trade Balance

Source: INE

How did we get here?

One of the commonly used explanations is that “the Portuguese lived beyond their means.” According to this view, Portuguese are to blame for spending rather than saving. This narrative seems as simplistic as it is deceptive. Olivier Blanchard (2006), a former IMF chief economist, has argued that there is a great diversity of factors that have led countries like Portugal to a situation of external imbalances. The French economist proposes “a natural explanation for these current account deficits” that is in line with “what theory suggests can and should happen when countries become more closely linked in goods and financial markets. To the extent that they are the countries with higher rates of return, poor countries should see an increase in investment. And to the extent that they are the countries with higher growth prospects, they should also see a decrease in saving.” Following this reasoning, “internal and external financial market liberalization” due to increased European integration, “future growth prospects” and “higher investment” are the main reasons for lower private saving. This was in fact what happened in Portugal. In the 80’s, the Portuguese economy suffered vivid changes. There was an immense influx of capital and accompanied by a massive privatization of the banking sector that contributed to a significant reduction in lending costs. The confidence in Portugal was booming and so the growth rates of GDP.  Naturally consumption and imports increased pro-cyclically as theory would suggest.

The aforementioned elements explain mainly the contribution of imports to the current account. However, to analyze the chronic current account deficit of the 90’s and 2000’s, one has to analyze also competitiveness-related factors. One of the most used indicators is the real exchange rate as a proxy of competitiveness. Portuguese data points to an appreciation which may be a sign of competitiveness loss because, simply putted, means that the prices in Portugal increased relatively to the foreign prices. However, we should not make definitive judgments only based on this indicator or even using real effective exchange rates due to its many defects (see Turner, P. e Van ‘t dack, J. (1993)). Another indicator widely used to analyze competitiveness is the Unit Labor Costs (ULC’s) that in the case of Portugal increased significantly. This might reflect excessive wage increases. Nonetheless, the use of ULC’s has some important caveats. For instance, Kaldor (1978) showed that after the World War II the countries where UCL’s increased the most were the ones that also expanded the most their market shares. In addition, Filipe and Kumar (2011) exposed that in aggregate terms the ULC’s are simply the labor’s share of income times the price deflator. The same authors conducted a rather interesting exercise proposing a similar indicator for Capital- unit capital cost—“the ratio of the nominal profit rate to the productivity of capital”. As in the case of ULC’s, the Unit Capital Cost increased due to faster rise in the nominator (nominal profit rate) than in the denominator (productivity of capital). From this can we conclude that capital costs have to decrease? It is hard to say just like it is hard to argue with accuracy that anytime that ULC’s rise, policy makers should promote wage reduction. One could say that this could help increase the nominal profit rate because of cost reductions (higher margins) but what is underlying this reasoning is that competitiveness gains are simply transfers from labor to capital, keeping productivity constant. Following this logic, one may also argue that low productivity was (still is) a problem for the Portuguese economy. Is hard to disagree. This is one of the main weakness point out by the existing literature. Portugal suffers from a chronical productive gap when compared to the EU’s average due to low qualifications and specialization in low productivity sectors. Having said this, what has been the evolution?  Back in 2006, Blanchard described the productive growth as “anemic”. However, a decade went by and recently his conclusions changed considerably due to the new available data: “the numbers reported for productivity growth were indeed extremely low, 0.3% on average for 2002-2007. The numbers have been revised and now show stronger productivity growth, 1.4% on average for the period! It may still be that the decrease in demand was due to expectations shaped by the numbers published at the time rather than current estimates (…) Part of the revisions come from a change in definition, from number of workers to number of full-time equivalents as a measure of employment” (Blanchard, 2017). This means that productivity growth was not as bad as initially perceived and may also be the case that increased flexibility of labor market might have been punished by the primary definition if the revised numbers are explained by changes in the denominator.

Instead of taking early conclusions merely based on the abovementioned indicators, we should dig a bit further. Portugal suffered a series of shocks that put its competitiveness at risk (Mamede, 2015). Countries with comparative advantages in terms of labor costs have entered the international markets with the enlargement of the European Union to the East and China’s accession to the WTO. Moreover, there was a continuous appreciation of the euro against the dollar.  Putting these two factors together, it is natural that Portuguese competitiveness suffer because of increased competition pressure in low tech sectors. Countries such as China, the Czech Republic or Poland not only had low labor costs relatively to Portugal but also had access to monetary policy to enhance competitiveness, an instrument no longer available for Portugal. In addition, the price of oil increased substantially, threatening the price competitiveness of the Portuguese economy. These shocks were particularly felt by the Portuguese economy due to the low level of qualifications of the workers that conditions the specialization profile of the Portuguese economy. In fact, there was a development of non-tradable sectors. Services and construction experienced an increasing share of total employment at the cost of industry and agriculture sectors. This might be a response to lack of competitiveness- not being able to compete internationally, it is normal that the structure of the economy changes towards the non-tradable sector. At a time when international trade increased significantly, the weight of exports in GDP stagnated. Only after 2005 there was a considerable increase until the crisis of 2008, although it was mainly motivated by the increase of raw materials processed by the emerging economies and consequent increase in the price of these goods.


Source: INE

How do we get out of here?

Portugal seems “stuck in the middle”. On one hand, the Portuguese economy cannot compete with high technological based economies because it lacks qualification skills. On the other, labor costs in low technological based economies are smaller than in Portugal. In order to be more competitive, it seems logical that the economy has to be more productive or costs have to decline. Productivity does not change by decree, it is a long process. Costs can adjust more rapidly but its effects may be quite severe. The economic crises of 2008 and the sovereign debt crisis of 2011 affected the Portuguese economy in a painful way. Hit by a sudden stop, Portugal required an external assistance program by Troika (ECB, IMF and EC). In this scenario, a period of austerity followed. As a consequence, labor costs were reduced but also unemployment rose and the economy contracted. In terms of trade, the deficit became a surplus.

At this stage, more than discussing if alternative policies (less painful) could have reached this result, is important to ask the following question: what to do from now on? Should policymakers try to continue to improve competitiveness in terms of costs? Labor costs reduction would be socially too costly. In addition, could threaten the recent economy recovery. Last but not least, with a low inflation level across Europe any policy that tries to decrease the real exchange rate may introduce deflation pressures in the economy (just look at Greece!).  We cannot assume that the competitive of the Portuguese Economy is solved but would counterproductive to follow the path of internal devaluation. Structural reforms that promote higher qualifications of the labor force, flexisecurity in the labor market as well as increased investment in high technological sectors should be some of the means to try to avoid be “stuck in the middle” and increase competitiveness in the long-run.

 Luís de Almeida, 30164 (Master in Economics Student)


Blanchard, Olivier. “Adjustment within the euro. The difficult case of Portugal.” Portuguese Economic Journal, vol. 6, no. 1, July 2006, pp. 1–21., doi:10.1007/s10258-006-0015-4

Turner, Philip, and Jozef Vant. Dack. Measuring international price and cost competitiveness. Bank for International Settlements Monetary and Economic Department, 1993.

Kaldor, N. 1978. “The Effect of Devaluations on Trade in Manufactures.” in Further Essays on Applied Economics. London: Duckworth.

Felipe, Jesus, and Utsav Kumar. “Unit Labor Costs in the Eurozone: The Competitiveness Debate Again.” SSRN Electronic Journal, 2011, doi:10.2139/ssrn.1773762.

Blanchard, Olivier, and Pedro Portugal. “Boom, slump, sudden stops, recovery, and policy options. Portugal and the Euro.” Portuguese Economic Journal, vol. 16, no. 3, 2017, pp. 149–168., doi:10.1007/s10258-017-0139-8.

Mamede, Ricardo Paes. O que fazer com este país: do pessimismo da razão ao optimismo da vontade. Marcador, 2015.


Thoughts on current economic indicators and the financial system

The financial crisis resulted in some important changes in the regulatory structure of financial institutes. These aimed to prevent another recession caused by the financial system. This paper explores macro indicators and relates it to the theory of the financial accelerator, to raise some questions on the stability of the current economic development. First, this article presents the theory and in the following empirical data is analyzed to show that the accelerator may amplify in future.

Banks are the core institutions in the financial system. They act as intermediaries between savers and lenders and provide the necessary capital to market participants [1]. Banks arise because there are information asymmetries between lenders and borrowers. Banks can reduce these asymmetries and the costs for lending and borrowing. Banks are specialized in information intense lending and mainly lend to small and medium-sized enterprises (SMEs), because within this lending operations, they can use their specialization and returns to exploit economies of scale. Big firms have higher credit volumes and therefore face relatively lower transaction costs. They use this advantage to access the capital market directly [2].

In their core business, banks face agency problems. As principals, they lend money to agents, which use the money to invest in projects. Under imperfect information, the bank has less information on the quality of the project than the agent. This gives rise to the issue that the bank cannot distinguish between good and bad borrowers. This leads to ineffective resource allocation. Furthermore, the risks are distributed asymmetrically. This may develop hidden intentions of debtors. It may be possible, that banks give money to lenders in the belief, the lender invests the money into a good project, but the lender uses the money to invest in another, riskier project. These issues are referred to as adverse selection and moral hazard [3]. To overcome these issues, the bank aligns their interests with the lender’s interests by using collateral. Collateral is an asset, which the lender is required to provide to the bank in case of default. The bank uses the asset to cover its losses resulting from the non-performing loan. The amount of collateral necessary is the loan-to-value-ratio and dependents on the risk aversion of the bank [4]. During economic growth banks have better future expectations and therefore increase the loan-to-value-ratio, whereas, during an economic downturn, they decrease it.

The use of collateral has important implications for the access to credit of households and firms in recessions. In an economic downturn output and production are declining. To overcome temporary output shocks, the economic agent wants to borrow money to smooth expenditure [5]. During downturns banks, however, adjust their risk attitude. When facing non-performing loans banks adjust the loan-to-value-ratio and demand higher collateral for borrowing. Since asset valuations are procyclic, the value of collateral decreases during the crisis. Both factors restrict agents from expenditure smoothing and amplify the downturn [3]. Furthermore, in crisis interest rates normally increase. Higher interest rates prevent people from accessing credit and amplify the effect portrayed above. These factors increase the external finance premium and restrict investment and spending expenditures. Furthermore, during a crisis, the percentage of bad firms in the economy increases. At the critical threshold, banks stop lending to SMEs due to adverse selection and switch to lending to big firms. Facing decreasing aggregate savings, big firms are not able to satisfy their financial needs only through direct finance and therefore demand finance from banks. This, however, leads to a crowding out of SMEs and cuts them off from accessing the financial system. Without access to finance, SMEs are threatened to become insolvent. This may result in additional layoffs and further puts pressure on demand. On the following, I want to investigate some dynamics which occurred during the years following the financial crisis.

Following the fiscal crisis in 2012-2013, the ECB reduced the interest level in the Euro area through open market operations, as well as by setting the interest rate on deposits negatively [6]. This had two major implications for banks. First, margins from lending decreased. To stay profitable, banks acquired more business to compensate lower margins with higher outstanding credit volume and therefore kept profits constant. This resulted in an increase of the balance sheets of financial institutions [7]. Since banks competed to acquire good investment projects, the proportion of bad projects increased over time. Still, under pressure for profitability and under asymmetric information, banks acquired bad projects, as well.

Second, as result of the declining interest level in the Eurozone and the global low-interest-rate environment, investors turned to different investment opportunities for additional returns. Higher demand for asset classes leads to increasing prices and inflated valuations of real assets [8][9][10]. Increasing asset prices resulted in higher valuations for collateral. Rising asset prices have a positive impact on the balance sheets of corporate and private customer, since their net wealth increases. This lowers the external finance premium and makes banks offer better conditions. This, in combination with a lower loan-to-value-ratio, enabled consumers and firms to receive more credit [11][12]. During an economic downturn, asset valuations normally decrease, and loans perform worse [13]. Since banks receive collateral to cover losses from non-performing loans, they may not be able to cover the losses completely after valuation declines. Since banks enlarged their portfolio with credit of unknown quality, this may have major impacts on the balance sheets and income statements of banks.

The increased balance sheets of banks translated into higher debt of households and firms. Ireland, Portugal, and Spain managed to reduce their private debt, but still, have a high private debt burden. Additionally, private debt in Greece, France, Belgium, and Finland increased continuously over the last years [11]. Further on, non-financial debt to surplus ratios in the Netherlands, Belgium, France, Portugal, Ireland, and Luxembourg continuously increased [8]. High debt ratios isolated do not need to be problematic since the GDP in these countries is recovering and growing [14]. However, in the case of an economic downturn, high debt has a rationing effect. The debt prevents households and firms from major expenditure and lets them cut their consumption and investment expenditures. Therefore, the bank does not lend to agents which are highly in debt or demands a higher interest rate. Both factors constrain additional spending and consumption smoothing.

Now assuming an economic downturn could trigger some of these effects and could amplify the crisis further. On the following, I want to investigate, how it would be possible, to stop a negative development. Well, the traditional Keynesian tools to counteract recessions are monetary policy and government intervention. Putting these under investigation in the Euro area, it is doubtful, whether these can make a major impact. The ECB set the interest already at zero and engages in open market operations to reduce the interest rates additionally. The effect of the transmission channel over the last years was already doubtful, looking at low investment stimulation, since the launch of the monetary expansion [15]. Therefore, the traditional tools of monetary policy are already exhausted, even if the open market operations are about to be reduced. Leaves us with government intervention. The fiscal crisis has been overcome, however, some countries in southern Europe still have high public debt [16]. This limits their ability to stimulate their national economy in case national demand is decreasing. Furthermore, since some countries are highly indebted, a recession may trigger doubts on the solvency of the countries again. This could cause additional political uncertainty.

So, what could trigger the economic downturn? There may are several factors, which could. Currently, business indicators show high optimism of economic agents [17] and the development of the Euro countries remains positive. However, the development is split between countries. While Germany and France are growing strongly, Greece, Portugal, Spain, and Italy remain fragile. Furthermore, investment is still low at the current stage of the business cycle and therefore may has a negative impact on future growth [15]. When the ECB ends its open market operations, this may result in reverting valuations. Other things like animal spirits or political uncertainty may trigger a loss of confidence and prudent inducted savings. However, these aspects are subject to speculation. More important than the fact, what could trigger a downturn is the question, whether the downturn may occur and whether the European economy is ready to face it. However, this goes beyond the aim of this article. For further analysis, I consider it interesting to investigate the above-portrayed aspects further and to highlight some policy implications to overcome the problems. This could benefit future growth and the resilience of the Eurozone.

Fabio Stohler (#30126)


[1] Allen, Franklin, and Santomero, Anthony, J. 2001. “What do financial intermediaries do?”. Journal of Banking and Finance 25 (2): 271-294.

[2] European Central Bank. 2001. “Financial Systems and the role of banks in Monetary Policy transmission in the Euro Area”. Frankfurt: European Central Bank Working Paper Series.

[3]Bernanke, Ben, Gertler, Mark and Gilchri, Simon. 1996. “The financial accelerator and the flight to quality”. The Review of Economics and Statistics 78 (1): 1-15. :


[5] Romer, David. 2012. Advanced Microeconomics. New York: McGraw-Hill.

[6] ECB. 2017. “Key ECB interest rates”. Accessed December 4.

[7] ECB. 2017. “Statistics Bulletin, Aggregated balance sheet of euro area MFIs”. Accessed December 4.

[8] Eurostat. 2017. “Housing price statistics – house price index”. Accessed December 4.

[9] 2017. “S&P 500 PE Ratio by Year”. Accessed December 4.

[10] ECB. 2017. “Statistics Bulletin, Credit Institutions and Money Market Funds balance sheets (full report)”. Accessed December 4.

[11] Tradingeconomics. 2017. “Euro Area Consumer Credit”. Accessed December 4.

[12] ECB. 2017. “Statistical Bulletin, Components and Counterparts”. Accessed December 4.

[13] Blanchard, Olivier. 2008. “The Crisis: Basic Mechanisms and Appropriate Policies”. Munich: Center for Economic Studies.

[14] EY. 2016. “Change of the gross domestic product (GDP) of the euro area up to 2019 (compared to the previous year)”. Accessed December 4.

[15] Financial Times. 2017. “Raise investment to maintain global growth, says OECD”. Accessed December 4.

[16] OECD. 2017. “Resilience in a time of high debt”. Accessed December 4.

[17] Financial Times. 2017. “Eurozone economic confidence hits 17-year high; 30-yr peak in hiring plans”. Accessed December 4.