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Second Quarter 2016
Volume 1, Issue 2
Fourth Quarter 2015

Volume 98, Issue 4

Housing’s Role in the Slow Economic Recovery
Chapter 11 for Countries?
Regional Spotlight: Pension Gap Perils
Research Update

ISSN: 0007-7011


Economic Insights is published four times

Housing’s Role in the Slow Recovery


a year by the Research Department of the
Federal Reserve Bank of Philadelphia. The views
expressed by the authors are not necessarily
those of the Federal Reserve. We welcome your
comments at PHIL

Why did homebuilding recover so slowly after the Great Recession?
Burcu Eyigungor examines some unusual supply and demand factors at
work during the boom and bust and explores why home construction is so
important to economic recoveries.

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Sovereign default risk is rising, yet the system for dealing with it remains
flawed. Satyajit Chatterjee explains why it may be time to revive a debt
restructuring proposal the international community rejected in 2003.

The Federal Reserve Bank of Philadelphia
helps formulate and implement monetary

Regional Spotlight: Pension Gap Perils


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is one of 12 regional Reserve Banks that,
together with the U.S. Federal Reserve

Pennsylvania and New Jersey’s pension systems are severely straining state
budgets, and Delaware’s also carry shortfalls. Elif Sen examines how
assumed rates of return on pension fund investments may not project the full
extent of the gaps.

Board of Governors, make up the Federal
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Research Update


Abstracts of the latest working papers produced by the Federal Reserve Bank
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Housing’s Role in the Slow Recovery
Why has homebuilding recovered so sluggishly after the Great Recession? The evidence
points to some unusual supply and demand factors.

Homebuilding contributed to overall economic growth
in every previous U.S. economic recovery since 1947, yet
contributed next to nothing in the first three years of the
recovery from the Great Recession. Home construction had
been such a reliable indicator of recovery that its failure to
promptly rebound led economists during the early years of
the recovery to repeatedly forecast that a housing turnaround was right around the corner. The magnitude of the
housing boom in the early 2000s was unprecedented, and
its effects on the housing sector lingered for years. As I will
show, the slow recovery in homebuilding and the economy
was partly a byproduct of the fast increase in house prices
and homebuilding in the early 2000s. To explore this dynamic further, I examine some key factors at work in this
period: What happened on the supply and demand sides of
the housing sector during this past boom and bust cycle?

Homebuilding — measured by the amount of money
spent on house and apartment construction, including
major renovations — is highly procyclical. In every recession
since 1947, the share of residential investment relative to the
gross domestic product (GDP) has fallen and then recovered
during the subsequent expansion (Figure 1). This pattern
implies that home construction is more volatile than GDP
in general: In a typical recession, residential investment declines more than GDP does.
The second well-established fact is that homebuilding
leads the business cycle.1 The recovery in homebuilding starts
on average two quarters before the recovery in general eco-


Homebuilding Is Highly Sensitive
to Recessions and Recoveries

Private residential fixed investment as share of gross domestic

Source: Bureau of Economic Analysis via Haver Analytics.

nomic activity. In that sense, home construction is an important jump-starter — that is, it precedes and makes possible
the overall economic recovery. Economists have also pointed
out that this lead/lag relationship might be due to monetary
policy — that is, lower interest rates first trigger a recovery
in housing because of easier mortgage financing, followed by recovBurcu Eyigungor is an
ery in other activities.2 Resideneconomic advisor and
tial investment has contributed
economist at the Federal
Reserve Bank of Philadelphia.
almost 1 percentage point to real
The views expressed in this
GDP growth on average in the
article are not necessarily
those of the Federal Reserve.
first year of a postwar recovery.

Second Quarter 2016 | Federal R eserve Bank of Philadelphia R esearch Department | 1


The housing boom from 1991 to 2005 was the longest
uninterrupted expansion of home construction as a share
of overall economic output since 1947 (Figure 1). During
the 1991 recession, private home construction had constituted 3.5 percent of GDP, and it increased its share of GDP
without any major interruptions to 6.7 percent in 2005. This
share was the highest it had been since the 1950s.
Just like the boom, the bust that followed was also
different from earlier episodes. During the bust, private
residential investment as a share of GDP fell to levels not
seen since 1947 and has stayed low even after the end of
the recession in 2009. In previous recessions, the decline in
residential construction was not only much less severe, but
the recovery in housing also led the recovery in GDP. As
Federal Reserve Chair Janet Yellen has pointed out, in the
first three years of this past recovery, homebuilding contributed almost zero to GDP growth.
The extra volatility in residential construction since
2000 is also observable in house prices, which when adjusted for inflation had been fairly stable from 1953 until
this past boom (Figure 2). The increase in real house prices
from 2000 to 2006 and the following crash were a big historical anomaly.
In this article, I will try to understand why home construction recovered so slowly this time around. First, I look
at the housing supply and whether the big increase in house
prices during the expansion led to overbuilding, meaning
that the recovery started with this extra supply hampering construction of new housing. Another possibility I will
explore is whether house prices fell so much in the bust that
home construction became unprofitable. As I will show, a
number of things on the demand side also changed.

If inventories of homes available to buy or rent are
high compared with demand, the amount of construction
required to satisfy that demand will be lower and might be
the reason behind the recent decline in homebuilding. For
a measure of inventories, I look at vacancy rates for both
rental and owner-occupied units. Rental vacancy rates were
higher than their historical averages during both the boom
and bust, while vacancy rates for owner-occupied homes
shot up in 2006, at the same time that house prices started
falling precipitously (Figure 3). More important, vacancy


An Unprecedented Rise in House Prices
House price index, 1953–2015.

Source: Census Bureau via Haver Analytics.

rates for both types of housing have recently fallen to levels
that had prevailed before the boom, which would seem to
indicate there is no longer an excess supply.
Then again, one might wonder whether these vacancy
rates capture the entire housing inventory. Some vacant
homes may not yet be for sale or rent but will be once they
are renovated — constituting what one might call a latent
supply of homes. Indeed, the ratio of all vacant homes —
not only those for sale or rent — to the stock of total housing (excluding vacation properties) started going up during
the housing boom, peaked around 2009, and has not come
down much since then (Figure 4).3 This latent supply might
explain some of the slack in construction.
Another driver of residential construction is house
prices: As demand for new houses drives up prices to profitable levels, construction firms respond by ramping up homebuilding. House prices fell steeply during the bust, but this
decline had been preceded by very large increases between
1999 and 2005. When adjusted for inflation, house prices
are still substantially higher than their historical averages
before 1999. So, why haven’t these high prices led to high
levels of residential construction during the recovery?
This puzzle raises an interesting question: Could it be
that prices are actually still too low? Do they need to rise
further for construction to pick up again? To answer that
question, we need to examine the profitability of the construction sector by comparing house prices with homebuilders’ costs. As construction worker payrolls account for 72
percent of homebuilders’ costs, the employment cost index
for total compensation of private construction workers is a

2 | Federal R eserve Bank of Philadelphia R esearch Department | Second Quarter 2016

house prices to employment costs remained below average
during much of the recovery and only by mid-2014 had returned to its preboom level (Figure 5).
We also see that profitability in the homebuilding industry indeed drives new home construction. When profits have
been low, construction spending has declined, and when
profits have been high, construction has gone up (Figure 5).
Still, the decline in home construction in the latest recovery
has been abnormally large. Given the historical correlation
between residential construction spending as a share of GDP
and profits as measured by the price-to-cost ratio, a normal
share for residential construction spending as a share of GDP
would have been more like 2.7 percent rather than the 1.3
percent we saw in the second quarter of 2014. As I will show,
there was also a sharp drop in demand for housing during
this recovery that may explain some of this gap between expected and actual residential construction spending.


Vacancies Have Recovered to Preboom

Source: Census Bureau Housing Vacancy Survey via Haver Analytics.



…But Vacancies Including Homes Off the
Market Still Elevated

Source: Census Bureau Housing Vacancy Survey via Haver Analytics.

reasonable measure of total costs in this sector.4
We also need an appropriate measure of house prices.
As city centers become more fashionable, it is possible that
house prices are increasing simply because the price of
urban land is increasing, which would not necessarily imply
that homebuilders’ profits are higher. Therefore, measures
that track sales of existing homes such as the S&P/Case–
Shiller house price index might give a misleading picture of
profitability, since older homes are typically found in locations with higher land values than houses built today are.
Indeed, judging by a measure that tracks prices for newly
built single-family homes, profitability went up from 2000 to
2006 but crashed in the 2007–09 recession, mostly because
of a plunge in the prices of new houses. The ratio of new

Two decisions that individuals and families make based
on their own circumstances end up having a major impact
on the whole housing market when taken all together. One
is whether to have a household of one’s own. The other is
whether to buy or rent one’s dwelling. Following the crash,
people’s responses to these two choices shifted in ways that
decreased overall housing demand: Both household formation and homeownership rates fell.
Household formation. Every time a new household
forms, it creates more housing demand, regardless of whether that new household decides to rent or buy a dwelling.5
If there is not enough inventory to meet the demand for


Profitability Drives Homebuilding

Ratios of new single-family house prices to employment
costs and residential investment to GDP.

Sources: Bureau of Economic Analysis and Census Bureau via Haver Analytics.

Second Quarter 2016 | Federal R eserve Bank of Philadelphia R esearch Department | 3

more housing, higher household formation will trigger more
homebuilding. Household formation peaked during the
boom, and it was persistently well below its historical average from 2007 until the end of 2014 (Figure 6). In no period
since 1956 has net household formation been so low for so
long. One can imagine how the extra household formation
during the expansion might have contributed to the decline
now. Because of the easy availability of mortgages during the
boom, people who ordinarily would have formed their own
households later in life might have done so sooner, implying
a lower household formation rate when mortgages become
hard to obtain again. In addition, when households default
on their mortgages and have to move in with other family
members, that decreases household formation.
Maybe the stark component of this picture is not the
initial decline in household formation following the crash,
which would be expected, but the persistence of the decline.
With the decline of foreclosure rates and unemployment,
household formation is back up again, but only after seven
years of sluggish performance.
One might wonder if part of this decline was due to the
aging of the population. Looking at the headship rate — the
proportion of householders in the adult population — we
see very large declines for all age groups between 2006 and
2013 (Table 1), so the aging of the population does not seem
to explain this persistent decline in headship rates.
There is another way of looking at this puzzle. Whether
someone can afford to be the head of a household usually
depends on whether he or she is employed. People move into
other households because of hardship, such as unemploy-

ment, and move out again when they can afford it. The ratio
of householders relative to employed people went up during
the crisis, mostly because employment fell so sharply (Figure
7). As employment falls, one would expect the number of
households to shrink as many unemployed householders can
no longer afford to maintain a home. But this process takes
time: Some householders default on their mortgages but remain in their homes rent- and mortgage-free while foreclosure proceedings continue. Some householders go through
their savings before moving in with someone else or even
become homeless. And households with two earners might
try to keep their own dwelling while the one who is unemployed searches for a job.
Although the number of householders relative to employed people might be affected by demographic factors and
marriage rates, between 2000 and 2008 (until the recession
hit), the ratio for people age 25 to 59 was quite stable at 65.8
percent. After the recession hit, the ratio went up to 68.4
percent in 2010, and it has been falling since then because
of both employment growth and low net household formation. By 2014 it had reached 65.9 percent, which is remarkably close to the ratio before the crisis hit. The fourth quarter of 2014 was also when household formation went back to
its prerecession rate. All this suggests that the householderto-employment ratio might be a quite good predictor (at
least in the short run) of future household formation.
Homeownership. Another major trend since the housing bust is the persistent decline for all age groups in the
homeownership rate, which had increased uninterruptedly
from 1995 to 2005 but has since fallen back in line with the
pre-1995 era, making it hard to predict whether this decline


Household Formation Well Below
Long-Run Average

Number of households formed in the prior year.


Headship Rate Has Fallen for All Age Groups
Percentage point change in proportion of householders
in adult population.

All ages

Source: Census Bureau Housing Vacancy Survey via Haver Analytics.
Note: Gaps in the 1950s and 1960s indicate incomplete data.

2000 –2006

2006 –2013

25 –29


30 –34



35 –39



40 – 44



45 – 49



50 –54



55 –59



60 – 64



Source: Census Bureau Housing Vacancy Survey via Haver Analytics.

4 | Federal R eserve Bank of Philadelphia R esearch Department | Second Quarter 2016



A Good Predictor of Future Household

Will Homeownership Resume Its Trend —
or Keep Falling?

Headship-to-employment ratio.

Source: Census Bureau Housing Vacancy Survey via Haver Analytics.
Sources: Census Bureau Housing Vacancy Survey; Bureau of Labor Statistics via Haver

will persist (Figure 8).6 Some have proposed that more stringent loan approval requirements have led to this decline. For
example, credit scores of those approved for purchase loans
have increased substantially, but it is difficult to identify
how much this increase is being driven by lower demand
by poorer households and how much by more stringency by
banks.7 One thing is certain: This decline has lowered overall housing expenditures, because homeowners on average
spend more on housing than renters do because of the tax
incentives of homeownership and holding a mortgage.8 Together, the declines in household formation and homeownership contributed to the decline in residential expenditures
as a share of GDP.

There is evidence that the slowness of the recovery in
housing contributed to the slowness of the overall recovery.
Recent research tries to understand this connection.
Atif Mian and Amir Sufi document a demand-side
effect of the sharp decline in house prices on employment.
Their argument is that house price declines reduced household wealth, which led homeowners to spend less and that
this drop in demand for goods and services in turn led to
the recession. They find wide geographic variation in how
households’ balance sheets were affected during the housing bust, as house prices declined more in some parts of the
country than in others, and households in some locales were
more debt-burdened on average than in other areas. Using

this variation, they find that locations that suffered the
biggest declines in housing wealth also had the biggest declines in employment.9 According to their calculations, the
decline in demand due to lower housing wealth accounts for
around 55 percent of the jobs lost between 2007 and 2009.
Another finding comes from Greg Kaplan: When
young householders get laid off, they may use their parents
as insurance and be more likely to move back in with them.
In addition, there is a positive long-term income effect of
moving in with one’s parents after a job loss. Comparing
20-year-olds who lost their jobs with those who did not, he
finds that after six years, the wages of those who lost their
jobs were 25 percent lower. But this difference arises mostly
because of the drop in wages suffered by people who did not
move in with their parents when they lost their job. People
who did move in with their parents had no statistically
significant income loss six years after being laid off. Kaplan
believes that this difference is due to the fact that young
people who move in with their parents can afford to take
longer to search for better jobs, so they end up earning higher wages in the long run. By contrast, those with no option
to move back home and who have to pay rent have to settle
for jobs even if they do not pay well or are not very suited to
their abilities. This study implies that as young people move
back with their parents, their job-finding rates fall, which
might explain some portion of the recent slow recovery.
This effect might be more pronounced in longer recessions
such as the recent one, as more young people than usual will
have moved back with their parents.10
Kyle Herkenhoff and Lee Ohanian find that, for a
household that stopped paying the mortgage, the aver-

Second Quarter 2016 | Federal R eserve Bank of Philadelphia R esearch Department | 5

age time spent in default increased from four months to 12
months during the crisis. They propose that this increase
may have led to higher unemployment rates. Being able to
live rent-free longer may have served as extra unemployment
insurance, giving unemployed delinquent mortgagors the
financial leeway to be choosier about what jobs they would
accept. They find that this effect increased unemployment
rates by an estimated one-half to one-third of a percentage
point in this recession and recovery.

Although homebuilding constitutes a small portion of
GDP — on average 4.7 percent since 1947 — it has outsize
importance for the rest of the economy. In general, the housing sector leads the recovery in the rest of the economy, and
the last recession suggests that without the housing sector, recovery is slow. Housing is also special in that housing wealth
is spread much more evenly across society than financial asset
wealth is, and so large falls in house prices affect middle-income people more than a similar decline in stocks does.
Therefore, it is important to avoid severe boom and
bust episodes in the housing market in the future. The
preventive steps that have been taken since the crisis —
stricter regulation of the banking sector to limit risk-taking
and more stringent requirements for mortgage borrowers —
might have slowed down this recovery but are necessary to
avoid a similar episode in the future.

Chatterjee, S., and B. Eyigungor. “A Quantitative Analysis of the U.S. Housing
and Mortgage Markets and the Foreclosure Crisis.” Review of Economic
Dynamics, 18:2 (2015), pp. 165–184.
Davis, Morris A., and Jonathan Heathcote. “Housing and the Business Cycle,”
International Economic Review, 46:3 (August 2005), pp. 751–784.
Elsby, M.W.L., B. Hobijn, and A. Sahin. “The Decline of the U.S. Labor Share,”
Brookings Panel on Economic Activity (Fall 2013).
Gervais, M. “Housing Taxation and Capital Accumulation,” Journal of
Monetary Economics, 49 (2002), pp. 1,461–1,489.
Goodman, L., J. Zhu, and T. George. “Where Have All the Loans Gone? The
Impact of Credit Availability on Mortgage Volume,” Journal of Structured
Finance, 20:2 (2014).
Herkenhoff, K., and L. Ohanian. “Foreclosure Delay and U.S. Unemployment,” Federal Reserve Bank of St. Louis Working Paper 2012–017A (2012).
Kaplan, G. “Moving Back Home: Insurance Against Labor Market Risk,”
Journal of Political Economy 120:3 (June 2012).
Kydland, F.E., P. Rupert, and R. Sustek. “Housing Dynamics over the Business
Cycle,” Centre for Macroeconomics Discussion Paper 2014–23 (2014).
Leamer, E.E. “Housing Is the Business Cycle,” National Bureau of Economic
Research Working Paper 13428 (2007).
Mian, A., and A. Sufi. “What Explains the 2007–2009 Drop in Employment?”
forthcoming in Econometrica.
Yellen, Janet. “A Painfully Slow Recovery for America’s Workers: Causes,
Implications, and the Federal Reserve’s Response,” speech, February 2013,

This relationship was first pointed out by Morris Davis and Jonathan
Heathcote. Edward Leamer has suggested that residential investment should
be used to predict the business cycle and should play a prominent role in
monetary policy.

one of the persons) in whose name the housing unit is owned or rented. If it
is a married couple living in the same unit, only the husband or wife would
be listed as householder; if unrelated roommates live in the same unit, again
only one would be recorded as the householder.

Finn Kydland, Peter Rupert, and Roman Sustek point out that the prevalent
use of fixed-rate mortgages in the U.S. might be why homebuilding leads the
business cycle in the U.S. They build a model to show how changes in interest
rates might lead homebuilding to respond earlier than other economic activity.

Again, this does not seem to be solely due to demographic changes, as
homeownership rates have declined significantly for all age groups.

Unfortunately, details on whether homes are vacant because of foreclosure
or for other reasons such as repairs are available only after 2012, which
makes it impossible to perform a more detailed analysis on why there are still
so many more vacant homes than before the crisis.

Martin Gervais and Satyajit Chatterjee and I have studied this phenomenon
in depth.


Michael Elsby, Bart Hobijn, and Aysegul Sahin give the payroll share for a
range of sectors.

The difference in the total number of households between periods gives
the number of new households formed during that interval. The Census
Bureau looks at the number of households each month. One person in each
household is designated as the “householder,” which refers to the person (or


See, for example, Laurie Goodman, Jun Zhu, and Taz George’s analysis.

More specifically, they had the biggest employment declines in nontradable
sectors — those that produce goods and services consumed domestically
rather than exported.

When we look at aggregate employment rates for different age groups, we
do not see that young people behaved very differently in this recession than
in earlier ones. But that might be because some people in all age groups had
to move in with other family members. As seen in Table 1, the headship rate
fell for all age groups between 2007 and 2013.

6 | Federal R eserve Bank of Philadelphia R esearch Department | Second Quarter 2016

Chapter 11 for Countries?
Sovereign default risk has been growing, yet the world lacks an adequate mechanism for
averting debt crises. It might be time to resurrect a plan modeled on the U.S. Bankruptcy Code.

For the past 40 years or so, every decade seems to have
brought its own brand of international debt problems. In the
1980s, emerging market economies, led by Mexico, defaulted
on their debt to private banks. In the 1990s, the fast-growing economies of Thailand, Indonesia, and South Korea teetered on the brink of default. The new millennium brought
the 2007–2008 financial crisis, the worst the U.S. had
experienced since the Great Depression. And this decade
has brought the ongoing Greek debt crisis, which for about
six months in 2011 had engulfed Italy, Spain, Portugal, and
Ireland and threatened to destroy the euro (Figure 1).
Although outright default on foreign borrowing is relatively rare — Argentina, Russia, Ecuador, and Greece have
been the only countries to default on their foreign obligations in the past 25 years — even the threat of sovereign

default can be very disruptive for countries that experience
it.1 Greece, sadly, is a poster child for the chaos that can
befall a country when investors begin to doubt its ability to
pay its bondholders. Greece was already suffering a recession
in 2010 when it became clear to investors that its government was under severe budgetary pressure. Greece’s debt was
eventually restructured to avoid outright default, but the
process was lengthy and extracted a heavy toll on the Greek
economy: By the end of 2013,
Greece’s gross domestic product
Satyajit Chatterjee is a
had fallen 25 percent below its
senior economic advisor and
GDP in 2010, and its unemployeconomist at the Federal
Reserve Bank of Philadelphia.
ment rate had climbed to 27
The views expressed in this
percent. Then, the recovery that
article are not necessarily
those of the Federal Reserve.
had begun in 2014 collapsed


Debt Crises over the Decades

Since 1980, roughly one-fifth of the world’s nations have had to resort to adjustment loans from the International Monetary Fund.


Second Quarter 2016 | Federal R eserve Bank of Philadelphia R esearch Department | 7

amid the political fallout from five years of harsh economic
policies, and in 2015 Greece defaulted on its interest payments to the International Monetary Fund (IMF). Although
an exit from the euro was averted, Greece’s economic situation remains dire.
In the wake of the Asian financial crisis of the 1990s,
the IMF had proposed a formal sovereign debt restructuring
mechanism (SDRM) that would have permitted an overly
indebted country to comprehensively restructure its foreign
debt quickly and equitably. Modeled on the segment of U.S.
corporate Bankruptcy Code commonly referred to as Chapter 11, the proposal was intensely debated but ultimately
shelved as it failed to garner the requisite support among
IMF member countries, the U.S. included. But since then,
the resurgence of international debt problems, in particular
Greece’s experience, has revived interest in adopting a sovereign debt restructuring mechanism.
As this article will explain, the risk of sovereign debt
crises is expected to rise over time, yet the current system
for dealing with both the threat and reality of sovereign
default is ill-suited to a world in which the primary source of
financing government capital projects is private investors in
other countries. Moreover, it is uncertain whether the main
policy initiative pursued by the U.S. in lieu of the SDRM
has lowered the likelihood of protracted and costly sovereign
debt restructurings. As we will see, the restructuring mechanism the IMF had proposed in 2003, or some variation of it,
continues to be worthy of consideration.

For much of the developing world, the benefits of borrowing in the capital markets of advanced economies are
immense. The demand in developing countries for investments in basic infrastructure such as electrification, communications, transportation, and education and health
facilities far outstrips what they can fund internally. At
the same time, new investment opportunities in advanced
economies are growing more slowly than in the past. In the
years to come, the benefits of borrowing from abroad will
entice more and more developing countries into the world’s
international capital markets, and investors looking for high
returns will gladly welcome them.
But more borrowing from abroad generally means a
higher likelihood of default. An obligation owed to creditors
is a fixed sum, but the amount of money available to repay
that obligation fluctuates randomly. Natural disasters, wars,
recessions, and political upheaval interfere with a country’s

ability to meet its obligations. Since emerging economies
tend to be more volatile, sovereign debt crises should become
more frequent as more capital flows to the developing world.
In addition, some features of the sovereign debt market
make emerging economies particularly prone to default.
Borrowing in the capital markets of New York, London, or
Tokyo means borrowing in dollars, sterling, or yen. But borrowing in a foreign currency exposes the country to currency
risk — the risk that its domestic currency will fall in value
relative to the currency in which its debt is denominated.
Currency devaluations can greatly increase the burden of
foreign debt overnight as more domestic currency is needed
to repay the same amount of foreign debt, and a country can
find it hard, even impossible, to pay its bondholders.2
As the events of the past seven years have shown,
rapidly growing national debt as a share of a country’s gross
domestic product can bring even advanced economies to
the brink of default. For advanced economies, the threat of
insolvency comes from long-term demographic trends that
are rapidly increasing their national debt burdens: Aging
populations are increasing government spending on social
security programs, public employee pensions, and healthcare subsidies while depressing tax revenue growth as labor
force participation declines. The global recession that followed the 2007–2008 financial crisis contributed to these
trends by temporarily shrinking government revenues and
rapidly raising national debt levels (Figure 2).3
Another troubling aspect of sovereign default is the
much-feared problem of contagion. When Argentina could
not pay its debt and sank into default in 2001, Uruguay also
suffered a recession, devaluation, and foreign debt crisis


National Debt Loads Face Short- and
Long-Term Pressure
Sovereign debt to gross national product.

Source: The World Bank’s World Development Indicators.

8 | Federal R eserve Bank of Philadelphia R esearch Department | Second Quarter 2016

because its exports to Argentina, Uruguay’s main trading
partner, collapsed. The interconnections among countries
resulting from trade links become the conduits through
which the “virus” of sovereign default jumps from one
country to another. Sometimes the virus spreads through
financial links.4 As trade linkages continue to widen and
as global financial markets increase in sophistication, such
links can be expected to permeate world capital markets. In
this interconnected world, sovereign defaults are unlikely to
be isolated events; they are more likely to come in waves.
Thus, no matter where in the world one looks, the
likelihood of sovereign debt crises is on the rise. How is the
international financial system dealing with a country’s inability to service its foreign debt? As we will see, the current
arrangement is not well adapted to a world where countries
borrow vast sums of money from private foreign investors.

What happens when a country runs into trouble and
is in danger of being unable to make timely payments to its
foreign creditors? Under the current arrangement, it does two
things. First, it seeks to restructure its existing debt, which
means asking its creditors to accept a partial write-off of their
loans or, failing that, to accept delayed repayment. Second,
it seeks temporary help from the IMF, which was set up after
World War II specifically to dispense such help. The IMF
might advance the country an adjustment loan and simultaneously force it to cut its fiscal budget in order to generate
surpluses that are then used to reduce its foreign debt to a
more manageable level. Once the country resumes making
timely bond repayments, international capital markets will
again be willing to buy new issues of its bonds, which the
country can then use to pay off its IMF adjustment loan.
As originally conceived, the IMF was intended to support a fixed international exchange rate system.5 Reflecting this narrow focus, IMF rules initially forbade it from
advancing loans to a country that had defaulted before
reaching a restructuring agreement with its creditors. An
adjustment loan was advanced only if the country was current on its obligations but was negotiating with its creditors
for a restructuring and was therefore temporarily unable to
issue new bonds in world capital markets. The arrangement
initially worked well, since at the time, a country’s foreign
debt was generally owed to foreign governments, which had
an implicit agreement to negotiate repayment quickly and
in good faith.

But this situation changed dramatically as private capital resumed flowing during the boom years of the 1960s and
early 1970s.6 When Mexico and other developing countries
defaulted in the early 1980s, the bulk of their foreign debt
was owed to commercial banks, not governments. And
reaching a restructuring agreement with the banks proved
to be a huge challenge. As the years passed, the pressure on
governments to get involved mounted. In 1989, the banks
accepted the fact that the countries were never going to be
able to repay their debts in full and, in return, agreed to accept bonds collateralized by U.S. Treasury securities as partial repayment on the defaulted loans.7 Because the bonds
were backed by U.S. government securities, the market value
of the bonds was greatly enhanced, which helped contain
the banks’ losses.
The resolution of the Latin American debt crisis was a
defining moment in the evolution of postwar international
borrowing and lending. The IMF had to change its rules to
permit adjustment loans to a country that had yet to reach a
settlement on its defaulted debt. This policy of lending into
arrears made it possible for the countries to purchase the
U.S. Treasury securities that backed the bonds offered to
the commercial banks in the settlement. Thus, the almost
decade-long impasse was ended by effectively orchestrating a
bailout of the commercial banks with IMF help.
However, the much-needed resolution of the Latin
American debt crisis left a thorny legacy for the IMF. On
the one hand, lending into arrears institutionalized a mechanism for bailing out foreign creditors following a default, although the IMF is loath to routinely activate this policy. On
the other hand, the bailout increased pressure on the IMF
for more bailouts.8 This dilemma led the IMF to propose a
formal mechanism that would smooth out the negotiation
process between creditors and countries in danger of falling
into default and thereby encourage them to seek a timely
restructuring of their unsustainable debt, while reducing the
need for the IMF to become a party to bailouts of private

Since debt crises occur only when countries lack the
money to make timely debt payments, any money that
goes to pay one creditor necessarily comes at the expense
of some other creditor. This basic fact pits one creditor
against another, with potentially adverse consequences. In
the corporate context, a creditor has the incentive to not

Second Quarter 2016 | Federal R eserve Bank of Philadelphia R esearch Department | 9

agree to the restructuring plan (making him a holdout) if he
believes that his threat of intransigence will compel other
creditors to accept bigger losses in favor of his getting more.
Such uncooperative behavior can unleash a war of attrition
among creditors — each holding out in the expectation that
others will capitulate first — and greatly delay agreement
on a restructuring plan. Since delays hurt all creditors, one
key purpose of bankruptcy law is to constrain the rights of
individual creditors for the benefit of all creditors. The U.S.
bankruptcy code serves this purpose by giving the bankruptcy judge the authority to bind all creditors to a restructuring plan approved by a majority of creditors — a cramdown
provision. Thus, an individual creditor gains nothing from
acting opportunistically when others act cooperatively.
A similar holdout problem can delay restructuring of
sovereign debt. The typical strategy of a holdout creditor is
to refuse to participate in a restructuring and to simply wait
for other creditors to agree to a restructuring plan and then
sue the country for full repayment. Because the country’s
debt burden is lower following a restructuring, the government may think it advisable to pay off the holdout and
avoid the nuisance of a suit, giving all creditors an incentive to hold out. Again, the resulting delay ends up hurting
both creditors and the debt-strapped nation. Thus, as in the
corporate context, a legal mechanism is required to counter
opportunistic behavior on the part of individual creditors.
The sovereign debt restructuring mechanism that
IMF officials proposed to their governing body in 2003
was designed to provide this legal mechanism.9 It gave a
country the right to unilaterally activate the mechanism
if it believed that its current debt exceeded its capacity to
repay (in U.S. bankruptcy law, the corresponding provision is known as filing for reorganization). Upon activation of
the mechanism, the country would be required to cease all
payments to creditors, and the creditors were enjoined from
litigating for full repayment (a stay) and would be required
to register their claims. Once all debts had been registered
and verified, the sovereign would be tasked with coming up
with an acceptable restructuring proposal (a reorganization
plan). During this renegotiation stage, the country could
get new loans that were outside the scope of the restructuring process and that would have priority for repayment over
all existing loans, provided a majority of creditors approved
such financing (priority or debtor-in-possession financing). If
creditors holding 75 percent of all claims accepted the plan,
it would become binding on all parties, including any dissenting creditors (a cramdown). The mechanism envisaged a
dispute resolution forum composed of impartial experts who

would mediate disputes that arose along the way. To give the
mechanism legal force, its adoption would occur via a treaty
among IMF member countries and, once adopted, would
govern the resolution of payment problems on all existing
and future sovereign debt.
The key to understanding the structure of the mechanism is the cramdown feature. In default, individual creditor rights are constrained to eliminate the holdout problem.
Given this suppression of their rights, all other features of
the mechanism are designed to protect creditor interests.
The mechanism is not an exact copy of U.S. bankruptcy
law: There is no bankruptcy judge who can impose a reorganization plan on all creditors. The role of the dispute
resolution forum is to facilitate agreement among creditors, not to impose any particular plan on them. Instead,
the mechanism requires a majority of creditors to agree to
the restructuring plan, which then becomes binding on all
Ostensibly, the mechanism does not ascribe a special
role to the IMF, but it is understood that the IMF would
have an important role to play. A country that activates the
mechanism loses access to world capital market but may
greatly need temporary priority financing. The entity most
well placed to provide such temporary priority financing is
the IMF. As per its rules, the IMF’s priority financing would
come with conditions: The country must announce a plan
to reduce its debt and then follow it. In this regard, the
mechanism institutionalizes the original conception of IMF
lending and much current practice, except that IMF help
becomes part and parcel of an overarching debt restructuring plan agreed to by the debtor country and its private
foreign creditors.

Why did the SDRM fail to take wing? In the debates that
led up to its rejection, two sorts of objections were voiced.
The first type questioned the wisdom of formalizing the restructuring process at all because of what that might mean for
all countries’ access to credit in the future. The second type
was more procedural: The need for an efficient sovereign debt
restructuring process was accepted in principle, but concern
focused on the nature of the proposed mechanism.
The first type of objection held that if restructurings
were made too easy, countries might be tempted to restructure too frequently.10 And, knowing this, lenders would lend
very little to governments in the first place. In economic
terms, this is the classic tradeoff between ex post benefits

10 | Federal R eserve Bank of Philadelphia R esearch Department | Second Quarter 2016

and ex ante costs. Ex post, a country in default would be better off having access to a restructuring mechanism that can
quickly and equitably reduce the burden of the debt. But ex
ante, the increased likelihood of a debtor-friendly restructuring following default will make creditors wary about lending
too much to them in the first place. Thus, credit will be
granted at worse terms — higher interest rates — making
repayment more costly, reducing a country’s debt capacity.
This concern resonated with investors and some emerging market governments. Brazil, for instance, argued that
the existence of the SDRM might make foreign lenders
reluctant to lend to emerging economies for fear they would
abuse the mechanism by restructuring too frequently.

The question is: What would happen to
governments’ debt capacity if an SDRM
were put into place?
The pivotal procedural objection questioned the necessity of an expensive, full-blown international mechanism
for solving the holdout problem.11 Instead, a contract-based
approach, which was already common in the U.K., ultimately
prevailed. In the U.K., a clause in corporate bond contracts
permits the debtor to change the payment terms for all bonds
in the same issue as long as a majority of holders of the bonds
in that issue favors the change. The new terms become binding on all bondholders, including dissenters. This clause —
called a majority action or collective action clause (CAC)
— serves the same purpose as a Chapter 11 cramdown by
taking away the incentive of individual creditors to act opportunistically. Since the use of CACs requires no change in
international law — only that the clause be enforceable in
the jurisdiction in which the bond is issued — it was viewed
as a lower-cost alternative to a formal SDRM.

It is certainly true that because creditors cannot grab
the assets of a nation in default, a costly and messy restructuring process is the main deterrent to default and that a
country will weigh the alternatives carefully before seeking
a restructuring of its foreign debt. As noted earlier, a strong
deterrent to default lowers the interest rate that countries

must pay on their debt, since lenders will charge a lower
premium to compensate them for the possibility of default.
This lower cost of borrowing increases governments’ debt
capacity. The question is: What would happen to their debt
capacity if an SDRM were put into place? As mentioned
earlier, some economists are of the view that by making restructurings all too easy, the SDRM would deal a death blow
to the sovereign debt market: Investors would respond by
greatly reducing the amount of money they lend to governments. Taking for granted that greatly reduced debt capacities will do great harm to nations that need to borrow, an
SDRM, in this view, cannot be a good idea.
However, most economists and legal scholars who have
scrutinized the SDRM proposal do not share this view.
Generally, it is understood that the point of the SDRM is
to reduce the costs of restructuring by taming the holdout
problem, not to reduce the costs of default. The thought
is that by providing a forum for renegotiations, the SDRM
would encourage overly indebted countries to negotiate with
lenders ahead of default. Thus, at the time of renegotiation,
the country would know that if it failed to come up with an
acceptable offer, it would have to suffer the costs of default.
Similarly, creditors would know that if they spurned all reasonable offers, they would end up with nothing, at least for
a while. Thus, both parties have an incentive to agree to a
reasonable restructuring plan.12
In this view, the presence of an SDRM should strengthen, not debilitate, the sovereign debt market. For instance,
it could open the door to other innovations: If creditors
publicly registered all claims against the distressed country,
the country may find it easier to implement a restructuring
process that gives priority to older claims over newer claims.
Such a system, which is common in corporate bonds but asyet unknown for sovereign bonds, can also protect creditors
and, hence, reduce the costs of foreign borrowing.13

After the SDRM proposal was shelved, the U.S. Treasury made a concerted effort to get emerging market governments to insert CACs into new sovereign bonds issued in
New York, where a large fraction of the world’s sovereign
bonds are issued. Mexico led the way in 2003, quickly followed by other Latin American countries. Now, nearly all
sovereign bonds issued in New York carry CACs. In Europe,
the Greek restructuring motivated the European Commission to make CACs mandatory in all sovereign bonds issued
by euro member countries since 2013. Does this prolifera-

Second Quarter 2016 | Federal R eserve Bank of Philadelphia R esearch Department | 11

tion of CACs obviate the need for an SDRM?
There is some indication that CACs are indeed effective in reducing the perceived likelihood of prolonged
restructurings. For countries with less-than-stellar credit
ratings, CAC-enhanced bonds have generally sold for higher
prices than bonds without CACs, suggesting that investors
perceive CACs as a force in favor of a speedier restructuring,
were one to become necessary.14
Still, there are reasons to think that CAC-enhanced
sovereign bonds are not a substitute for an SDRM. First,
CAC-enhanced bonds are relatively new, and a large stock
of sovereign bonds outstanding do not bear this clause. Until this stock of pre-CAC bonds matures or is bought back,
the safeguards that the new CAC-enhanced bonds offer will
be less potent.15 A high-profile court ruling in the U.S. has
significantly enhanced the bargaining strength of holdout
creditors by giving them the power to interfere with debt
repayment to creditors who agree to a restructuring. This
remarkable development occurred with regard to litigation
between holdout investors and Argentina following a restructuring of its sovereign debt in 2005 (Argentina’s bonds
had no CACs). This precedent makes it more profitable for
investors specializing in distressed sovereign bond funds to
pursue governments for full repayment. Many commentators have pointed out that this development will make it
harder for countries to reach restructuring agreements on
bonds without CACs that involve a substantial reduction in
Second, CAC-enhanced sovereign bonds have found
willing buyers only if the threshold for collective action is
relatively high. Generally, creditors holding 75 percent, and
in some cases more, of a particular issue would have to agree
to any binding change in payment terms. The 75 percent
threshold would seem to be the same as the one proposed in
the SDRM, but that is not the case. The SDRM threshold
had applied to total registered debt, while the CAC threshold applies to each issuance of bonds. For many countries,
the amount of debt outstanding is small compared with the
overall size of international capital markets, and their bonds
sell at a steep discount when they are having difficulty meeting payments. It is then relatively easy for so-called vulture
funds to buy up more than 25 percent of an issue and hold
out for full payment. For instance, about half of Greece’s
sovereign bonds issued under U.K. law escaped restructuring
because it was relatively easy for holdouts to purchase blocking shares in these issues, and payments on these bonds are
being made as originally contracted.17
Third, if investors indeed prefer CAC-enhanced bonds,

one has to wonder why the clause did not become popular
earlier. Legal scholars have pointed out that New York bond
attorneys were well aware of CACs but used them sparingly
in sovereign bond contracts.18 This suggests that CACs
became popular largely because the U.S. Treasury leaned
on governments to use them and that countries complied
in form — but not in spirit — by choosing a relatively high
threshold for collective action. But why, then, did CACenhanced bonds sell at higher prices than non–CACenhanced bonds? The explanation may be mismeasurement.
Because the switch from regular to CAC-enhanced bonds
was so quick, researchers are limited to comparing the
price of regular bonds issued prior to 2003 with the price of
CAC-enhanced bonds issued after 2003.19 This unfortunate
fact leaves open the possibility that the premiums on CACenhanced bonds rose because some other factors changed
right around 2003. One possibility is that investors became
more willing to invest in risky assets such as emerging
market sovereign bonds as interest rates on safe assets such
as U.S. Treasuries fell to historic lows in the post-2002
So, while CACs provide some safeguard against holdouts — a 75 percent threshold is better than a 100 percent
threshold — it might be premature to conclude that the
proliferation of CACs in sovereign bonds issued under New
York law has paved the way for smooth restructurings.

It is difficult to look at the postwar era of international
borrowing and lending and not come away thinking that we
are witness to a bad case of misaligned incentives. Creditors, reasonably confident that bailout packages will allow
them to recover most of their money, lend at rates that do
not reflect the true risk of default. Governments, faced with
willing lenders and fearful of the costs of default, keep on
borrowing until the day of reckoning is upon them. The
IMF, unable to countenance a messy default by a country
important to the global economy, be it emerging or advanced, comes through with the anticipated bailout, and
foreign investors get their loans paid off.
This situation could be remedied by the sovereign debt
restructuring mechanism proposed by the IMF back in 2003.
The SDRM provides a legal mechanism for dealing with
repayment problems that accompany the flow of private
capital to governments. The existence of an SDRM would
facilitate timely restructurings when foreign obligations become excessive (because the impediments to restructurings

12 | Federal R eserve Bank of Philadelphia R esearch Department | Second Quarter 2016

would be reduced), reduce the likelihood of excessive foreign
borrowing (because creditors would be more circumspect of
the possibility of restructurings and attendant losses), and
eliminate bailouts (because the IMF would feel less impelled
to intervene if there is a palatable alternative to outright
default). Although the spread of CACs has been a positive
development, their effectiveness remains uncertain because
of the high thresholds required for collective action and
because of the large stock of foreign debt outstanding that
does not carry CACs.

In the meantime, the risk of sovereign debt crises is
growing, especially in the developed world, where demographics and politics are conspiring to rapidly increase
countries’ indebtedness. Since advanced economies have a
large footprint in world capital markets, many commentators have expressed alarm over the situation. These developments — Greece’s debt crisis included — led the IMF to
take a second look at the desirability of an SDRM and have
led some economists to strongly endorse the idea of a formal
restructuring mechanism.21

For the purposes of this article, sovereign default describes a situation
in which a country quits trying to repay its creditors or must obtain an
international bailout. Depending on how broadly default is defined, several
more countries have defaulted during this time. For instance, Carmen
Reinhart defines sovereign default as the failure to meet a principal or
interest payment on the due date (or within the specified grace period) or
episodes where rescheduled debt is ultimately extinguished in terms less
favorable than the original obligation and offers a longer list of countries
that defaulted from 1990 to 2015.

Many developing countries rely on commodity exports to earn foreign
currency, but commodity prices are notoriously volatile, causing large
fluctuations in the value of their domestic currency. In addition, emerging
economies often attempt to peg the value of their currencies to major foreign
currencies such as the U.S. dollar. Such pegging succeeds if the country has
large reserves of foreign currencies. But if reserves shrink as the country’s
ability to earn foreign currency is impaired, the peg becomes unsustainable
and the currency devalues massively.

In Ireland, for example, the national debt exploded because the government
nationalized private sector debt in an effort to contain the fallout from the
financial crisis. In the U.S., the government-sponsored enterprises Fannie
Mae and Freddie Mac became wards of the state, so their debts have now
become the obligation of the U.S. government.
For instance, a mutual fund company that creates a fund focused on
emerging markets would naturally include a whole raft of countries in the
fund in order to diversify risk. But if default by one country in the fund
causes investors to reduce their exposure to the fund itself, the fund will
have to reduce its holdings of the sovereign bonds of all countries in the
fund, including those not directly affected by the default. Thus, the threat
of default in Mexico caused stock markets in Argentina and Brazil to drop
in 1995 even though direct trade links among these countries are quite
minimal. See Roberto Rigobon’s monograph for an in-depth discussion of

In the aftermath of the Asian crisis, the policy was expanded to allow
lending into arrears resulting from defaults on nonbank debt (bonds). See
the IMF’s 1999 publication for a discussion of the evolution of its lending in
arrears policy.

For details of the proposal, see Anne Krueger’s 2002 IMF article and the
actual proposal submitted to the governing body of the IMF in February
See Andrei Shleifer’s short article, provocatively titled “Will the Sovereign
Debt Market Survive?”

This objection was voiced by John Taylor, then undersecretary for
international affairs at the U.S. Treasury Department.

Of course, the mechanism could be abused. For instance, a rogue nation
could activate it over and over again, making a mockery of the restructuring
process. But such behavior could be discouraged by requiring countries to
wait a certain number of years between activations. A similar limitation
exists in the U.S., where one can file for personal bankruptcy no more often
than every seven years.

Giving older claims priority in a restructuring means imposing fewer losses
on older claims relative to newer claims. Burcu Eyigungor’s Business Review
article explains why giving priority to older claims benefits countries, and
Patrick Bolton and David Skeel’s article explains how the SDRM can make it
possible to implement such a priority rule.

The premium does not apply to countries with stellar credit ratings because
their likelihood of a restructuring is low. See Michael Bradley and Mitu
Gulati’s 2014 article for a thorough discussion of the perceived investor
valuation of CACs. Also, it is worth pointing out that the evidence on the
price effects of CACs is somewhat mixed. An earlier study by Torbjörn Becker,
Anthony Richards, and Yunyong Thaicharoen had found no evidence that
investors viewed CACs either positively or negatively.

For most emerging market economies, the secondary market for their
sovereign debt is relatively illiquid. This means that the country must offer
an attractive price to its current bondholders (pension funds, for instance)
to entice them back into the market and swap their existing debt for CACenhanced debt. Since such swapping does not seem to be occurring on a
large scale, we may infer that the cost of enticing investors to trade old debt
for new debt is too high — even though the pension funds would have paid
more for CAC-enhanced bonds had they been offered initially.

The book by Barry Eichengreen provides a concise history of the
international financial system.

For a brief history of the Latin American and emerging market debt crises,
These collateralized bonds became known as Brady bonds and the
restructuring plan the Brady plan, after then U.S. Treasury Secretary Nicholas
Brady, who had advanced it.

Second Quarter 2016 | Federal R eserve Bank of Philadelphia R esearch Department | 13

See, for instance, the Financial Times article and the brief filed by Anne
Krueger in favor of Argentina’s appeal to deny holdout creditors the power to
obstruct payments to creditors who had agreed to the restructuring in 2005.


This experience has led the euro zone to mandate “super-CAC” clauses in
all sovereign debt issued by euro member countries since 2013. A super-CAC
clause makes it possible for creditors as a group to override holdouts on any
given issue, provided there is enough support (over all issues combined)
for the restructuring. Still, even such super-CAC bonds are not entirely
bulletproof against determined holdouts.

See the 2013 article by Mark Weidemaier and Mitu Gulati for a discussion
of the use of CACs in sovereign bonds issued under New York law before

Bradley and Gulati examine the diffusion of CAC-enhanced bonds among
new issuances of sovereign bonds under New York law; see their figures 1
and 2 (p. 2,050).


The inflation-adjusted yield on long-term U.S. Treasury bonds has moved
up and down over the last 200 years. Nevertheless, as documented in
Eichengreen’s paper, post-2002 yields are low in comparison with yields
during the previous half-century (see his figure 1). Also, we know from
numerous accounts that the six years preceding the 2007–2008 crisis was
an era of high finance in which vast sums of money flowed into all sorts of
risky investments. Also, while the crisis caused investors to retreat from
mortgage-backed securities and related financial products, they thronged to
emerging markets in search of higher yields.


The IMF’s second look is discussed in the 2013 article on sovereign debt
restructuring. For the views of a distinguished group of economists and
legal scholars regarding the desirability of a sovereign debt restructuring
mechanism, see the 2013 report of the Committee on International Economic
Policy and Reform. There is also growing international recognition that the
world needs a multilateral sovereign debt restructuring process to replace
the current flawed system. The United Nations General Assembly in 2015
adopted a resolution on the principles that should guide sovereign debt
restructuring processes.

Becker, Torbjörn, Anthony Richards, and Yunyong Thaicharoen. “Bond
Restructuring and Moral Hazard: Are Collective Action Clauses Costly?”
Journal of International Economics, 61 (2003), pp. 127–161.
Blustein, Paul. The Chastening: Inside the Crisis That Rocked the Global
Financial System and Humbled the IMF. New York: Public Affairs, 2003.
Bolton, Patrick, and David Skeel. “Inside the Black Box: How Should a
Sovereign Bankruptcy Framework Be Structured?” Emory Law Journal, 53
(2004), pp. 763–822.
Boughton, James M. Silent Revolution. The International Monetary Fund
1979–1989, Washington, DC: IMF, 2001.
Bradley, Michael, and Mitu Gulati. “Collective Action Clauses for the
Eurozone,” Review of Finance, 18 (2014), pp. 2,045–2,102.

International Monetary Fund. “Proposed Features of a Sovereign Debt
Restructuring Mechanism,” February 12, 2003.
International Monetary Fund. “IMF Policy on Lending into Arrears to Private
Creditors,” June 14, 1999.
Krueger, Anne O. Amicus Curiae in Support of the Republic of Argentina and
Reversal, United States Court of Appeals for the Second Circuit, January 4,
Krueger, Anne O. “A New Approach to Sovereign Debt Restructuring,”
International Monetary Fund, April 16, 2002.
Reinhart, Carmen M., and Kenneth S. Rogoff. This Time Is Different: Eight
Centuries of Financial Folly. Princeton: Princeton University Press, 2009.

Committee on International Economic Policy and Reform. “Revisiting
Sovereign Bankruptcy,” October 2013.

Rigobon, Roberto. International Financial Contagion: Theory and Evidence
in Evolution, The Research Foundation of the Association of Investment
Management and Research, August 2002.

Eichengreen, Barry. “Secular Stagnation: The Long View,” National Bureau of
Economic Research Working Paper 20836 (2015).

Shleifer, Andrei. “Will the Sovereign Debt Market Survive?” American
Economic Review, 93:2 (2003), pp. 85–90.

Eichengreen, Barry. Globalizing Capital: A History of the International
Monetary System. Princeton, NJ: Princeton University Press, 1996.

Taylor, John. “Sovereign Debt Restructuring: A U.S. Perspective,” paper
presented at a conference on Sovereign Debt Workouts: Hopes and Hazards,
Institute for International Economics, Washington, DC, April 2, 2002.

Eyigungor, Burcu. “Debt Dilution: When It Is a Major Problem and How to
Deal with It,” Federal Reserve Bank of Philadelphia Business Review (Fourth
Quarter 2013).

Financial Times. “Vulture Hedge Funds Set to Target Unprotected
Government Debt,” November 12, 2014.
International Monetary Fund. “Sovereign Debt Restructuring — Recent
Developments and Implications for the Fund’s Legal and Policy Framework,”
April 26, 2013.

United Nations General Assembly, Draft Resolution A/69/L84. “Basic
Principles on Sovereign Debt Restructuring Processes,” September 10, 2015,
Weidemaier, C. Mark, and Mitu Gulati. “A People’s History of Collective
Action Clauses,” Virginia Journal of International Law, 54:1 (2013),
pp. 51–95.

14 | Federal R eserve Bank of Philadelphia R esearch Department | Second Quarter 2016

Pension Gap Perils
Are the significant shortfalls in tristate public pension funds actually far worse than official
reports suggest?

Pennsylvania and New Jersey’s underfunded public pension systems have severely strained their state budgets and
put their taxpayers at risk of bearing a potentially significant
financial burden. Though Delaware’s gap is considerably
narrower, its pension assets also fall short of liabilities. By
some estimates, the shortfall between promised state pension benefits and available funding in the three states totals
nearly $103 billion, and the potential per capita tax burden
as of 2013 ranged from $1,179 in Delaware to $5,728 in New
Jersey. Yet, as serious as this sounds, is the problem actually
significantly worse?
The size of a state’s pension gap matters of course to its
active and retired workers, but also to all its residents. That’s
because pension obligations are promises — more legally
binding in some states than others — to make payments
to workers at a future time. Failing to accumulate enough
money to make good on these promises can force states to
raise taxes or cut programs, or both.
How can a pension plan be reasonably sure it will meet
its obligations? First, a plan needs to adhere to an actuarially
determined schedule of contributions to the pension fund.
Second, plans rely on the growth of their funds, which are
invested in stocks, bonds, and other investments.
These assets and future benefits — liabilities, from the
plan’s perspective — both need to be measured in today’s
dollars in order to determine the plan’s health. Because of
the time value of money, $100 to be paid out sometime in
the future is worth less than $100 paid out today, so the
future value of liabilities must be discounted to determine
the present value.
Like most state plans in the U.S., tristate plans use

the assumed rate of return on their invested assets as their
discount rate to calculate the present value of total liabilities. Although economists, analysts, and legislators debate
what is an appropriate discount rate assumption for pension funds, many financial economists argue that current
assumptions are too high and that the discount rate should
be independent of the rate of return of assets. As this article
will show, the discount rate used can make a major difference in funds’ health status.

The state retirement systems included in this article
cover approximately 1.5 million active and retired public
sector employees in a variety of occupations — including
state government office workers, public school employees,
and law enforcement personnel — through defined benefit
pension plans for which the state is the sponsor, administrator, employer, or funder (Table 1).1
To get a picture of the health of these systems, we examine trends for each state from 2003 to 2013 in four key
pension fund status indicators — actuarial accrued liabilities
and assets, funded ratios, unfunded actuarial accrued liabilities, and annual required contributions.2
Actuarial accrued liabilities
and assets. Actuarial accrued

liabilities represent the present value of future obligations
to pension plan members, and
assets represent the value of the

Elif Sen is a senior economic
analyst at the Federal Reserve
Bank of Philadelphia. The
views expressed in this article
are not necessarily those of
the Federal Reserve.

Second Quarter 2016 | Federal R eserve Bank of Philadelphia R esearch Department | 15



Tristate Pension Plans Analyzed

State Employees’ Retirement System
Public School Employees’ Retirement System

Gaps Have Widened Since Recession
Total liabilities vs. actuarial value of assets.













Public Employees’ Retirement System
Teachers’ Pension and Annuity Fund
Police and Firemen’s Retirement System


Consolidated Police and Firemen’s Pension Fund
Prison Officers’ Pension Fund
State Police Retirement System
Judicial Retirement System
Public School Employees’ Retirement System
State Employees’ Pension Plan
New State Police Pension Plan
Judiciary Pension Plan
County and Municipal Police Firefighters
County and Municipal Other Employees
Volunteer Firemen
Diamond State Port Corporation


State Police Retirement System (Closed)
Teachers’ Pension and Annuity Fund
Police and Firemen’s Retirement System
Consolidated Police and Firemen’s Pension Fund
Prison Officers’ Pension Fund
State Police Retirement System
Judicial Retirement System
Public School Employees’ Retirement System

Sources: Pew Charitable Trusts and individual plans’ Comprehensive Annual Financial
Reports (CAFRs).
Note: Membership counts are as of fiscal 2013 and were obtained from individual plan
CAFRs. The listed plans are those included in the Pew state pension database.

pension plan’s investments, or the valuation assets (Figure
1).3 In all three states, the growth of total liabilities outpaced the growth of assets from 2003 to 2013, though the
divergence was not as sharp in Delaware. Over that same
period, liabilities grew 66.3 percent in Pennsylvania, 55.4
percent in New Jersey, and 74.3 percent in Delaware, while
assets grew more slowly, at 3.9 percent, 4.4 percent, and
53.0 percent, respectively.
From these actuarial accrued liabilities and assets are
derived two main indicators of a plan’s health — the funded
ratio and unfunded liabilities.
The funded ratio. The funded ratio is the ratio of assets
to liabilities. It indicates how well funded a plan is at a given
point in time. A funded ratio of less than 100 percent means
a pension fund’s assets do not cover its liabilities. Funded
ratios declined among all 50 states on average from 2003
to 2013 (Figure 2). Though Delaware’s funded ratio was
comparatively high, it declined from slightly more than 100
percent — more than fully funded — in 2003 to 88 percent
by 2013. Pennsylvania’s funded ratio declined more, by 37

Source: Pew Charitable Trusts.

percentage points, to 62 percent. Similarly, New Jersey’s fell
31 percentage points to 63 percent.
Unfunded actuarial accrued liabilities. The unfunded
actuarial accrued liability — calculated as actuarial accrued
liabilities less actuarial accrued assets — represents obligations not covered by assets, or pension debt. As one would
expect given the increasing divergence of liabilities and
assets, unfunded liabilities increased in all three states from
2003 to 2013 (Figure 3). Delaware’s plans had been slightly
overfunded in 2003, by $26 million, yet by 2013 its unfunded
liabilities exceeded $1 billion. Pennsylvania and New Jersey’s
unfunded liabilities sat above $50 billion in 2013, more than
two and a half times the 50-state average of $19.4 billion.
The trends in these indicators show deterioration in
overall funding health for all three states and sharp increases in unfunded liabilities for Pennsylvania and New
Jersey. So, what happened over those years? Many factors

16 | Federal R eserve Bank of Philadelphia R esearch Department | Second Quarter 2016


Funding Deteriorated Everywhere
Funded ratios.

Source: Pew Charitable Trusts.


A Damaging Decade
Unfunded liabilities.

Source: Pew Charitable Trusts.

impact the size of unfunded liabilities, and in any given year,
unfunded liabilities will grow or decline based on contributions and investment returns as well as on any changes to or
deviations from plan benefits or assumptions.
For instance, market downturns can play a large role
in the health of pension plans. A 2015 study examined the
impact of some of these factors, including investment returns
and contribution cutbacks, on the growth of unfunded liabilities for 150 state and local plans in the United States from
2001 to 2013 — a period that included both the aftermath
of the dot-com stock bubble and the Great Recession.4 The
analysis found that more than 60 percent of the increase in
unfunded liabilities occurred as a result of lower-than-as-

sumed investment returns during this period. By contrast, the
study attributed about 24 percent of the rise in unfunded liabilities to insufficient contributions — that is, contributions
that were smaller than what was needed to cover obligations.
As might be expected, poor returns strongly affected
every plan, and contributions likewise fell short for all plans
during this period. Even so, plans whose average funded ratios were lower during the period generally experienced bigger increases in unfunded liabilities, with inadequate contributions accounting for a greater share of the rise than they
did among well-funded plans. Among poorly funded plans,
inadequate contributions accounted for about 33 percent of
their increase in unfunded liabilities, versus 13 percent for
well-funded plans.
By contrast, well-funded plans were hurt more than
poorly funded plans by lower-than-assumed returns, which
accounted for nearly 70 percent of the increase in unfunded
liabilities among well-funded plans versus about 55 percent
among poorly funded plans.
Unfunded liabilities pose potential financial burdens
on taxpayers and increase pressure on government revenues
and spending. On a per capita basis, unfunded liabilities
soared in all three states from 2003 to 2013, from $21 to
$3,950 in Pennsylvania, from $667 to $5,728 in New Jersey,
and from negative $32 to $1,179 in Delaware. The size of
Delaware’s unfunded liabilities in 2013 amounted to nearly
33 percent of its total tax revenues. For Pennsylvania and
New Jersey, unfunded liabilities amounted to 149 percent
and 175 percent, respectively, of total tax revenues.
Annual required contributions. Pension plan financial reports also include information on annual required
contributions, which are determined by actuarial methods.
The required contribution for each year — “required” not in
the legal sense but in the sense of staying on a path toward
full funding — equals the sum of the cost of benefits earned
by active employees during that year, known as the normal
cost, and an amortization payment.5 Put simply, if the annual required contribution is made over the next 20 to 30
years, the pension fund will meet all its obligations over that
period. While Delaware made annual contributions in line
with its required amounts, Pennsylvania’s and New Jersey’s
contributions were consistently well below their required
amounts (Figure 4).

Clearly, the four key indicators highlight significant
gaps in tristate pension plans. Yet, are these shortfalls actu-

Second Quarter 2016 | Federal R eserve Bank of Philadelphia R esearch Department | 17


Pennsylvania, New Jersey Consistently
Below Target
Annual required contributions vs. actual contributions.

Source: Pew Charitable Trusts.

ally far worse than official reports suggest?
The status of a pension fund, including its liabilities,
depends on the actuarial methods and assumptions used,
which vary by plan and state. Economists, analysts, and
policymakers continue to debate how best to value plan liabilities and, thus, the true size of funding gaps.
Recall that actuaries incorporate demographic factors
(retirement age, life expectancy, etc.) along with economic
factors (salary increases, investment returns, inflation,
etc.) in determining the total pension liability and then
discount the total to arrive at the present value of future
benefits. It follows then that the rate used to discount the
total pension liability — another assumption that needs to
be made — has a significant impact on the calculation of a
plan’s total liabilities.
Underlying the debate over how to value liabilities is
disagreement over what an appropriate discount rate assumption is for calculating the present value of future pension fund obligations.
Most state pension plans in the U.S. apply a discount
rate that corresponds to the assumed rate of return on their
assets to discount liabilities. However, researchers Robert
Novy-Marx and Joshua Rauh note that pension payments
are extremely likely to be made, as they are legal obligations,
while stocks and other risky investments have uncertain outcomes.6 Therefore, they argue, liabilities should be measured
independently of how pension funds are invested.
Most states, including our three states, use a discount
rate of 7 to 8 percent. While this may be reasonable given

the historical average stock market return of approximately
11 percent, Novy-Marx and Rauh speculate that, to be able
to call their pensions funded, states could simply adopt
riskier investment strategies with higher expected returns
while still holding insufficient assets.
Is there evidence of the use of such strategies? According to a recent Pew report on state pension investments,
three-quarters of state retirement systems’ assets in the United
States are invested in stocks and “alternative investments,”
which is an ambiguous term but generally includes private equity, hedge funds, real estate, and some commodities. These
alternative investments “can be employed to diversify investment portfolios or to achieve higher rates of return, although
often at higher levels of risk.” From fiscal 2006 to fiscal 2013,
the share of pension funds’ portfolios allocated to these alternative investments more than doubled, from 11 percent to 25
percent, while the share invested in stocks decreased from 61
percent to 49 percent.
Citing standard financial theory, Novy-Marx and Rauh
argue that pension obligations should be discounted at a
rate that reflects their risk, and “in the case of state pension
funds, the ‘risk’ is the level of certainty as to whether certain
payments will need to be made.” That is, since there is a 100
percent certainty that pension benefits will need to be paid
out, pension funds should be invested in financial instruments whose returns are just as certain. That leaves U.S.
Treasury bills and bonds, which, because they are backed by
the full faith and credit of the U.S. government, are considered essentially risk-free. Note that such certainty comes at
a steep cost: Interest rates on Treasuries are generally much
lower than returns on riskier investments and currently remain near historical lows.
When Novy-Marx and Rauh used liabilities as officially
reported by the 116 largest state public pension plans in the
nation in 2008, they calculated total unfunded liabilities of
more than $1 trillion. However, when they used liabilities
discounted by the Treasury rate, total unfunded liabilities
rose to $3.23 trillion.
Recommending what discount rate to use is beyond the
scope of this article. However, to demonstrate the sensitivity
of liabilities to the discount rate used, we can create simple estimates of the unfunded pension liability for each of the three
states for 2013 under alternative discount rates. Table 2 shows
total liabilities at different discount rates and the resulting unfunded liabilities and funded ratios for each of the three states.
Here we can see, for example, that if a discount rate of only 4
percent were applied to Pennsylvania’s pension funds instead
of 7.5 percent, the reported unfunded liabilities would be more

18 | Federal R eserve Bank of Philadelphia R esearch Department | Second Quarter 2016


Assumed Discount Rate Has Big Impact		
Discount rate, percent
Total liabilities, billions
PA Total assets, billions
Unfunded liabilities, billions
Funded ratio, percent
Discount rate
Total liabilities
NJ Total assets
Unfunded liabilities
Funded ratio
Discount rate
Total liabilities
DE Total assets
Unfunded liabilities
Funded ratio

As reported in 2013

Under alternative discount rates
126.0 160.6 205.8
172.8 221.3

Sources: Pew Charitable Trusts and author’s calculations.
Notes: Estimates are based on the assumed rate of return reported for the largest plan in each state and
also use the discount rate as reported in the second column. For calculations under alternative discount
rates, total liabilities as reported in 2013 were projected forward for 13 years at the assumed rate of
return, and then discounted back at the alternative discount rate. Because plan durations vary, revaluations of liabilities are based on a common duration period of 13 years, consistent with Moody’s Investors
Service’s propietary methodology to adjust state pension data, a description of which is available with
subscription at

than double and the funded ratio would be more than 20 percentage points
lower for 2013.

Traditional defined benefit pensions promise set payments,
while under today’s more common defined contribution
retirement plans, such as 401(k)s, no set payouts
are promised.
The data for the state retirement systems included in
this article cover 2003 to 2013 and come from the Pew
Charitable Trusts state pension database, which aggregates
each state’s plans’ financial information. The systems
included in the database are “those listed in the state CAFR
[Comprehensive Annual Financial Reports] in which the state
is a sponsor, administrator, employer, or funder,” and “local
pension systems with no direct state involvement are not
included.” For consistency in financial reporting standards,
the data used in the analysis go through fiscal 2013.
Assets are often reported as a smoothed market value
to lessen the impact of short-term market volatility on
reported values. The data shown in this article were
reported using smooth five-year average asset values under
the Governmental Accounting Standards Board (GASB)
Statement 25. As a result, data for 2013 still included losses
sustained in 2009 due to the financial market downturn
during the Great Recession. Effective with fiscal 2014
reports, GASB adopted Statement 67, an amendment of
Statement 25, which changes how assets and liabilities are
disclosed in plans’ CAFRs. Among the changes to reporting
standards under GASB 67, unfunded pension liabilities or
net pension liabilities (calculated as the difference between
liabilities and assets) will be based on the market valuation
of assets and not smoothed investment gains and losses over
a period of years.

See the analysis by Alicia Munnell, Jean-Pierre Aubry, and
Mark Cafarelli. The Public Plans Database they used includes
data for the Delaware State Employees, New Jersey Public
Employees, New Jersey Police and Fire, New Jersey Teachers,
Pennsylvania Public School Employees, Pennsylvania State
Employees, Pennsylvania Municipal, and Philadelphia
Municipal retirement systems and plans.

Applying a lower discount rate would, of course, not resolve the
pension crisis. At best, all it can do is make the magnitude of the
problem clearer. That said, a more realistic picture could be a first step
toward action to close the funding gap.

The new accounting standards under GASB 67 replaced the
annual required contribution with the actuarially determined
employer contribution. Both measurements represent the
normal cost plus an amortization payment; however, while
GASB 25 had established parameters for the calculation
of the annual required contribution, GASB 67 places no
limitation on the calculation of the actuarially determined
employer contribution. In their June 2015 brief, Munnell and
Aubry found that most plans in their Public Plans Database
continued to use the same methods and assumptions to
calculate an annual contribution in fiscal 2014.

Mennis, Greg. “The State Pensions Funding Gap: Challenges Persist,” Pew Charitable Trusts
Mennis, Greg. “Making State Pensions Investments More Transparent,” Pew Charitable Trusts
Munnell, Alicia H., and Jean-Pierre Aubry. “The Funding of State and Local Pensions:
2014–2018,” Center for Retirement Research at Boston College State and Local Pension Plans
in Brief, 45 (June 2015).
Munnell, Alicia H., Jean-Pierre Aubry, and Mark Cafarelli. “How Did State/Local Plans Become
Underfunded?” Center for Retirement Research at Boston College State and Local Pension
Plans in Brief, 42 (January 2015).
Munnell, Alicia H., and Laura Quinby. “Legal Constraints on Changes in State and Local
Pensions,” Center for Retirement Research at Boston College State and Local Pension Plans in
Brief, 25 (August 2012).
Novy-Marx, Robert, and Joshua D. Rauh. “The Liabilities and Risks of State-Sponsored
Pension Plans,” Journal of Economic Perspectives 23:4 (2009), pp. 191–210.

The degree to which pension obligations are protected,
however, varies by state. Most states, including our
three states, protect pensions under contract theory. Any
legislation changing the terms of the contract is subject
to court review. See the brief by Alicia Munnell and Laura
Quinby for more detail. Pension benefits are contractually
protected for past and future accruals in Pennsylvania and
past accruals in Delaware (once the employee is eligible for
retirement) and New Jersey. Future accruals protection in
New Jersey is unclear.


Second Quarter 2016 | Federal R eserve Bank of Philadelphia R esearch Department | 19

Visit our website for more abstracts and papers of interest to the professional researcher produced by economists and
visiting scholars at the Philadelphia Fed.


The authors test the hypothesis that income inequality causes financial distress. To identify the effect of income
inequality, they examine lottery prizes of random dollar
magnitudes in the context of very small neighborhoods (13
households on average). The authors find that a C$1,000
increase in the lottery prize causes a 2.4% rise in subsequent
bankruptcies among the winners’ close neighbors. They also
provide evidence of conspicuous consumption as a mechanism for this causal relationship. The size of lottery prizes
increases the value of visible assets (houses, cars, motorcycles), but not invisible assets (cash and pensions), appearing
on the balance sheets of neighboring bankruptcy filers.
Working Paper 16–04. Sumit Agarwal, National University of Singapore; Vyacheslav Mikhed, Federal Reserve Bank of
Philadelphia Payment Cards Center; Barry Scholnick, University of Alberta.

The authors explore the role of consumer risk appetite
in the initiation of credit cycles and as an early trigger of
the U.S. mortgage crisis. They analyze a panel data set of
mortgages originated between the years 2000 and 2009 and
follow their performance up to 2014. After controlling for all
the usual observable effects, the authors show that a strong
residual vintage effect remains. This vintage effect correlates well with consumer mortgage demand, as measured by
the Federal Reserve Board’s Senior Loan Officer Opinion
Survey, and correlates well to changes in mortgage pricing
at the time the loan was originated. The authors’ findings
are consistent with an economic environment in which
the incentives of low-risk consumers to obtain a mortgage
decrease when the cost of obtaining a loan rises. As a result,
mortgage originators generate mortgages from a pool of
consumers with changing risk profiles over the credit cycle.

The unobservable component of the shift in credit risk, relative to the usual underwriting criteria, may be thought of as
macroeconomic adverse selection.
Working Paper 16–05. Joseph L. Breeden, Prescient Models
LLC; José J. Canals-Cerdá, Federal Reserve Bank of Philadelphia Supervision, Regulation, and Credit.

The authors use a large data set on retail pricing to document that a sizable portion of the cross-sectional variation
in the price at which the same good trades in the same period and in the same market is due to the fact that stores that
are, on average, equally expensive set persistently different
prices for the same good. The authors refer to this phenomenon as relative price dispersion. They argue that relative
price dispersion stems from sellers’ attempts to discriminate
between high-valuation buyers who need to make all of their
purchases in the same store and low-valuation buyers who
are willing to purchase different items from different stores.
The authors calibrate their theory and show that it is not
only consistent with the extent and sources of dispersion in
the price that different sellers charge for the same good, but
also with the extent and sources of dispersion in the prices
that different households pay for the same basket of goods
and with the relationship between prices paid and the number of stores visited by different households.
Working Paper 16–06. Greg Kaplan, Princeton University
and National Bureau of Economic Research; Guido Menzio,
University of Pennsylvania and National Bureau of Economic
Research; Leena Rudanko, Federal Reserve Bank of Philadelphia Research Department; Nicholas Trachter, Federal Reserve
Bank of Richmond.

The authors analyze a labor market with search and
matching frictions in which wage setting is controlled by a
monopoly union. Frictions render existing matches a form of
firm-specific capital that is subject to a hold-up problem in a

20 | Federal R eserve Bank of Philadelphia R esearch Department | Second Quarter 2016

unionized labor market. The authors study how this hold-up
problem manifests itself in a dynamic infinite horizon model
with fully rational agents. They find that wage solidarity,
seemingly an important norm governing union operations,
leaves the unionized labor market vulnerable to potentially
substantial distortions because of hold-up. Introducing a
tenure premium in wages may allow the union to avoid the
problem entirely, however, potentially allowing efficient hiring. Under an egalitarian wage policy, the degree of commitment to future wages is important for outcomes: With full
commitment to future wages, the union achieves efficient
hiring in the long run but hikes up wages in the short run
to appropriate rents from firms. Without commitment, and
in a Markov perfect equilibrium, hiring is well below its efficient level both in the short and the long run. The authors
demonstrate the quantitative impact of the union in an extended model with partial union coverage and multiperiod
union contracting.
Working Paper 16–07. Leena Rudanko, Federal Reserve
Bank of Philadelphia Research Department; Per Krusell, Stockholm University, Center for Economic and Policy Research, and
National Bureau of Economic Research.

The recent decline in small business lending (SBL)
among U.S. community banks has spurred a growing debate
about the future role of small banks in providing credit to
U.S. small businesses. This paper adds to that discussion in
three key ways. First, the authors’ research builds on existing
evidence that suggests that the decline in SBL by community banks is a trend that began at least a decade before the
financial crisis. Larger banks and nonbank institutions have
been playing an increasing role in SBL. Second, the authors’
work shows that in the years preceding the crisis, small
businesses increasingly turned to mortgage credit — most
notably, commercial mortgage credit — to fund their operations, exposing them to the property crisis that underpinned
the Great Recession. Finally, the authors’ work illustrates
how community banks face an increasingly dynamic competitive landscape, including the entrance of deep-pocketed
alternative nonbank lenders that are using technology to
find borrowers and underwrite loans, often using unconventional lending practices. Although these lenders may pose a
competitive threat to community banks, the authors explore
emerging examples of partnerships and alliances among
community banks and nonbank lenders.
Working Paper 16–08. Julapa Jagtiani, Federal Reserve

Bank of Philadelphia Supervision, Regulation, and Credit;
Catharine Lemieux, Federal Reserve Bank of Chicago.

In this paper, the author uses a statistical model to
combine various surveys to produce a term structure of inflation expectations — inflation expectations at any horizon
— and an associated term structure of real interest rates.
Inflation expectations extracted from this model track realized inflation quite well, and in terms of forecast accuracy,
they are at par with or superior to some popular alternatives.
Looking at the period 2008-2015, the author concludes that
long-run inflation expectations remained anchored, and the
policies of the Federal Reserve provided a large level of monetary stimulus to the economy.
Working Paper 16–09. S. Borağan Aruoba, Federal
Reserve Bank of Philadelphia Research Department Visiting

In this paper, the authors incorporate a search-theoretic
model of imperfect competition into an otherwise standard
model of asymmetric information with unrestricted contracts. They develop a methodology that allows for a sharp
analytical characterization of the unique equilibrium and
then use this characterization to explore the interaction
between adverse selection, screening, and imperfect competition. On the positive side, the authors show how the structure of equilibrium contracts — and, hence, the relationship
between an agent’s type, the quantity he trades, and the
corresponding price — is jointly determined by the severity of adverse selection and the concentration of market
power. This suggests that quantifying the effects of adverse
selection requires controlling for the market structure. On
the normative side, the authors show that increasing competition and reducing informational asymmetries can be
detrimental to welfare. This suggests that recent attempts
to increase competition and reduce opacity in markets that
suffer from adverse selection could potentially have negative,
unforeseen consequences.
Working Paper 16–10. Benjamin Lester, Federal Reserve
Bank of Philadelphia Research Department; Ali Shourideh,
University of Pennsylvania Wharton School; Venky Venkateswaran, New York University Stern School of Business;
Ariel Zetlin-Jones, Carnegie Mellon University.

Second Quarter 2016 | Federal R eserve Bank of Philadelphia R esearch Department | 21



Structural DSGE models are used both for analyzing
policy and the sources of business cycles. Conclusions based
on full structural models are, however, potentially affected
by misspecification. A competing method is to use partially
identified VARs based on narrative shocks. This paper asks
whether both approaches agree. First, the author shows
that, theoretically, the narrative VAR approach is valid in
a class of DSGE models with Taylor-type policy rules. Second, the author quantifies whether the two approaches also
agree empirically, that is, whether DSGE model restrictions
on the VARs and the narrative variables are supported by
the data. To that end, the author first adapts the existing
methods for shock identification with external instruments
for Bayesian VARs in the SUR framework. The author also
extends the DSGE-VAR framework to incorporate these
instruments. Based on a standard DSGE model with fiscal
rules, the author’s results indicate that the DSGE model
identification is at odds with the narrative information as
measured by the marginal likelihood. The author traces
this discrepancy to differences both in impulse responses
and identified historical shocks.
Working Paper 16–11. Thorsten Drautzburg, Federal
Reserve Bank of Philadelphia Research Department.

Can competition work among privately issued fiat currencies such as Bitcoin or Ethereum? Only sometimes. To
show this, the authors build a model of competition among
privately issued fiat currencies. The authors modify the current workhorse of monetary economics, the Lagos-Wright
environment, by including entrepreneurs who can issue their
own fiat currencies in order to maximize their utility. Otherwise, the model is standard. The authors show that there
exists an equilibrium in which price stability is consistent
with competing private monies but also that there exists a
continuum of equilibrium trajectories with the property that
the value of private currencies monotonically converges to
zero. These latter equilibria disappear, however, when the
authors introduce productive capital. They also investigate
the properties of hybrid monetary arrangements with private
and government monies, of automata issuing money, and the
role of network effects.
Working Paper 16–12. Jesús Fernández-Villaverde, University of Pennsylvania, National Bureau of Economic Research,
and Center for Economic Policy and Research; Daniel Sanches,
Federal Reserve Bank of Philadelphia Research Department.

22 | Federal R eserve Bank of Philadelphia R esearch Department | Second Quarter 2016

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