Public and private deleveraging in the euro area

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We study how public-sector and private-sector deleveraging jointly impact the macroeconomic performance of individual euro-area countries after 2009. Private-sector deleveraging are efforts by households and firms to reduce borrowing levels. Such efforts may be due to deliberate decisions by borrowers in light of reduced net worth and less benign income prospects or imposed by lenders. Public-sector deleveraging are efforts by governments to reduce borrowing levels. Such efforts may include cuts to government spending and transfer payments or tax hikes (austerity for short). In both instances such efforts may raise the level of debt relative to current GDP because of contractionary effects on economic activity. Our main indicator for macroeconomic performance is the unemployment rate. We focus on both efforts jointly, since they are a) prime suspects when it comes to accounting for the dismal macroeconomic performance in the euro area, b) conceptually closely related, and c) likely to interact such that potentially adverse dynamics are reinforcing each other. We pursue two objectives. The first objective is to quantify the distinct contribution of both private-sector deleveraging and public-sector deleveraging to the macroeconomic performance of individual euro-area countries after 2009. The second objective is to analyse at a theoretical level how alternative measures of public-sector deleveraging interact with (or even induce) private-sector deleveraging. Moreover, in this context we also explore the distributional implications of austerity and determine the optimal composition of public deleveraging in terms of social welfare.We conduct our analysis within a structural model which captures key features of a small open economy operating inside a currency union. In order to quantify the contribution of deleveraging to the macroeconomic performance, we calibrate the model to individual euro-area countries of the southern periphery, solve the perfect-foresight version of the model and run counterfactual experiments. In order to meet the second objective, we consider an extended version of the model and solve it under uncertainty. In this case, we are able to capture changes in precautionary savings by households in response to austerity measures, that is, we allow for an endogenous component of private-sector deleveraging.The project breaks new ground along two dimensions. First, while we rely on a fairly standard model, we do not resort to perturbation methods in solving the model. Instead, we solve the model globally while allowing for uncertainty. We are thus able to capture non-linear dynamics and, in particular, the interaction of private and public deleveraging. Second, our analysis will inform the ongoing debate about the role of austerity measures in accounting for the dismal macroeconomic performance in the euro-area periphery. This debate is currently not sufficiently grounded in state-of-the-art methods of macroeconomic analysis.