Two recent papers -- Mian, Rao, and Sufi and Mian and Sufi -- have contained the kind of detailed empirical analysis of the Great Contraction that's been rare. The first shows that at the zip code level, high debt-to-income is associated with a fall in consumption, and that within counties, a high number of subprime borrowers is associated with a decline in auto sales. This is a decent test of the hypothesis that household debt has played a major role in the slump. The second finds that while tradeable sector job losses have been uniformly distributed, non-tradeable sector job losses have been greater in highly leveraged counties. This is consistent with the "fall in aggregate demand" story of the contraction, but is hard to square with supply-side theories like uncertainty or structural unemployment. It's not proof that the recession was demand-side (there are no proofs in empirical science), but it's a strong argument.

Their most challenging finding is that the shock to household balance sheets explains 65% of job losses in their data. It's the product of an economic model, which isn't gospel, but it implies that household debt is the heart of the problem. The question, then, is whether debt effects dominate any wealth effect over and above them. We know that the fall in house prices led to lower consumption. Is this mostly because banks were less willing to lend to homeowners? Or was it mostly because homeowners were less willing to spend? The answer matters because the two views imply different easiest ways out: direct debt relief vs fiscal stimulus.

Mian, Rao, and Sufi find the decline in consumption is much larger than previous studies on the wealth effect would suggest. This could also be explained by a "fear multiplier" making consumers much more cautious after 2008, however. Meanwhile, the incresae in the saving as a proportion of income has been comparatively small. That measure may be misleading, however, since real income shrunk. What we care about is the marginal saving rate.

An interesting experiment that will never happen would be to randomly select a bunch of people and give them $10K each, and see how much of that turns into consumption as a function of debt and wealth. Maybe use two groups: one that gets $10K cash and another that gets $10K of their mortgage paid off. The design isn't perfect -- we'd want some data from before the crisis to compare it to -- but it would be informative. Failing this, modelling observational data on consumption as a function of both debt and wealth would be useful but hard.

See also: Mike Konczal's interview with Amir Sufi.

No:

Fiscal space analysis purports to tell us how much a country can add to its (gross) public debt before the interest burden becomes unsustainable, if fundamentals remain constant. So the table says NZ could add 220% of its GDP to its public debt, which would give a total of 256%. These numbers, espeically the latter, shouldn't be taken literally. It's just a regression prediction, and it depends on inputs. The Moody's paper also gives a lower estimate of 178% fiscal space, or 214% total public debt, under a different interest rate assumption.

Furthermore, fiscal space can shrink rapidly when fundamentals change -- ask Iceland. But not only does NZ have a lot of fiscal space compared to other wealthy nations, it can survive a huge jump in bond rates. When fiscal space is calculated according to Moody's main set of assumptions, they recommend maintaining at least 125% fiscal space.

We're nowhere near the limit now. The calculations are interesting in that they give an indication of how much trouble we could be in if there's another crisis. The 125% rule suggests that NZ could deploy expansionary fiscal policy as long as gross debt peaked below 131%, assuming no decline in fundamentals. A moderate shock, like a Greek default, would leave us far short of the danger zone, implying we could spend our way out of recession. This doesn't mean that's the right policy, only that it wouldn't put us at significant risk of default. A huge shock, like complete disintegration of the eurozone, changes so much that the calculation has to be re-done. In any case, fiscal space analysis is not a substitute for analysis of the bond market. Fortunately, with the bond rate hovering around a record low 4%, the bond market is currently easy to analyse. So, again, the answer to the title question is no.

The eurozone lurches back toward a break-up.

The highest priority at the Brussels summit had to be to find the money to bail out Italy or Spain, should that become necessary. Without that money, there's no confidence -- a small ripple could cascade into a bond market collapse, and after the run starts, there won't necessarily be time to get the money together before contagion sets in.

The EFSF and its successor, the ESM, don't have the firepower to deal with a run on Italy or Spain. The ECB is currently content to sit on its hands (mustn't risk 4% inflation, now). I guess the hope is that if a run on a country starts, the ECB immediately comes out of its shell and snuffs it out before it spreads. Given this is exactly what didn't happen in Greece, one might have doubts.

How could the EU lower the risk of needing bailouts, without enlarging bailout funds? They're betting on austerity. (This might not achieve much in itself, but could give the ECB cover to act.) The trouble is that for any kind of fiscal union to have strength, it requires, at the least, all 17 eurozone states to sign on, and preferable the other 10 EU states as well. There doesn't seem to be much prospect of Britain chipping in, so the deal-making has largely been confined to the 17. But enforcing austerity in 17 out of 17 countries? Merkel might be able to foist it on her populace. But the peripheral countries won't be happy. Look at the resistance in Greece to austerity measures: you think you won't see the same thing in the rest of the PIGS? With inflation targets remaining low, you're asking countries to sign on to years of deflation to save the euro, and for a lot of the citizenry, that's not in their interest. That Merkel wants treaty changes only makes co-operation less feasible.

The best way out is still ECB money. In the absence of this, fiscal co-ordination could help, but it would require something that every single eurozone country could sign on to. The only way I can see this happening is if Germany accepts higher inflation. Failing that, any success would be indistinguishable from luck.

Though the news from the eurozone has been better this past week, it's clear that the risk of a euro break-up is high enough to necessitate thinking about contingency plans. So what should the Government and the Reserve Bank do if the unthinkable happens?

Of course this depends on the course of the break-up. If one or more of the PIGS leave, then while those holding money in the drop-outs would face devaluation and losses, those holding money in the reduced eurozone would win as the euro appreciated. It's not zero sum -- the losers would lose enough to cause some destabilisation. But in NZ, the ripples, though unpleasant, would probably be manageable. My guess is conventional monetary policy could handle it. Drop the cash rate to near zero, allow a little inflation but keep an eye out for bubbles. The government could help by explicitly condoning inflation up to, say, 4%.

The worse scenario is a total euro break-up, which could happen if Germany decide to take their ball and go home. The only certainty would be that lawyers would make a killing. My guess is that this would be worse than 2008. If so, NZ and Australia would have to co-ordinate policy. My short-term solution would be to nationalise a big chunk of the financial industry. Have some stimulus ideas bottled up, then release them as necessary as the crisis plays out.

National would never do this, which is one reason to be happy the Germans look willing to stay the course.

Welcome to another edition of Brad Paraphrases the Economist.

The eurozone, as is frequently mentioned this blog, is screwed. Britain, though a combination of xenophobia and good sense, managed to keep their own currency. Yet it looks like the euro crisis will drag them down as well. British banks have a ton of money sunk in the continent, and a severe credit drought there will spread across the Channel.

In the US, however, there are enough green shoots that optimism can't be dismissed with sarcasm. Reports are in of the private sector expanding fast enough to dent unemployment, though it remains to be seen whether this is a blip. The American banks aren't heavily exposed to the Eurodrama, reducing the possibility of instability in the event of a meltdown.

S&P just cut the Aussie banks' ratings, but it was a pretty pro forma cut and no one seems to care. The Oz banks have some direct exposure to the eurozone, as well as to shaky wholesale markets elsewhere. On the other hand, retail deposits are doing fine, thank you, as people remain risk-averse and are willing to park their savings in banks at low interest rates.

The Aussie banks are our banks, so the interesting (read: terrifying) question is how heavily a drying up of credit in Europe and elsewhere will hit them. Italy remains the domino of interest. We can be fairly confident that a Greek default won't kill us, but if Italy goes, France and Germany take a huge hit, and in turn everyone else takes at least a big hit. We're certainly not in a position to bail out the Oz banks if it comes to that, so all we can do is keep a close eye on what they're holding, and yell at them if they're taking too much risk.