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Transcript of Kansas City Fed Paper
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1
RedistributiveMonetaryPolicy1
MarkusK.BrunnermeierandYuliySannikovPrinceton
University
August,2012
Abstract
Liquidity
and
deflationary
spirals
self
generate
endogenous
risk
and
redistribute
wealth.
Monetary
policycanmitigatetheseeffectsandhelprebalancewealthafteranadverseshock,therebyreducing
endogenousrisk,stabilizingtheeconomy,andstimulatinggrowth.Theredistributivechanneldiffers
fromtheclassicKeynesianinterestratechannelinmodelswithpricestickiness.Centralbanksassume
andredistributetailriskwhenpurchasingassetsorrelaxingtheircollateralrequirements.Monetary
policy(rules)canbeseenasasocialinsuranceschemeforaneconomybesetbyfinancialfrictions.As
withanyinsurance,itcarriesthecostofmoralhazard.Redistributivemonetarypolicyshouldbestrictly
limitedtoundoingtheredistributioncausedbytheamplificationeffectsandbymoralhazard
considerations.
1Thispaperwaspreparedforthe2012JacksonHoleSymposiumhostedbytheFederalReserveBankofKansas
City,August31toSeptember1,2012.WearegratefultoTobiasAdrian,EvanFriedman,MasazumiHattori,Nobu
Kiyotaki,JeanPierreLandau,HyunShin,LarsSvensson,MarkWatson,andespeciallytoDelwinOlivanforhelpful
suggestions.
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1.Introduction
Shorttermdebtfinancingplayedanimportantroleintherunuptothefinancialcrisis,asincreasesin
leveragehelpedboostgrowthbutalsomadetheeconomymoresusceptibletoasharpdownturn. Since
therecession,privateagentshavereducedtheirdebtlevelwhilemanypublicgovernmentshave
increasedborrowing. Thisdeleveragingprocessappearstobeholdingbacktherecovery,andthe
Japaneseexperiencesuggeststhatsuchdeleveragingcancontinueoveranextendedperiod.
Economicactivitydependsonwealthdistributionandtheriskbearingcapacityofvarioussectorsand
actorsintheeconomy.Inaworldwithexcessivedebtfinancing,amplificationofadverseshockscan
triggerlargewealthredistributionsacrossandwithinsectorsthatstiflegrowth. InJapan,thenon
financialbusinesssectorsufferedmostfromliquidityanddeflationspirals,whilecurrently,intheUnited
States,thehouseholdsectorlargelybearsthecostsofthesespirals.
Thispaperarguesthatmonetarypolicycanmitigatetheredistributiveeffectsoftheadverse
amplificationmechanismsandhelprebalancewealthacrossvarioussectorsandhouseholds.The
wealthredistributivemonetarytransmissionchannelworksthroughchangesinassetpricesand
profitability.Thekeyinsightisthatsinceeconomicagentsdifferintheirassetholdings,monetarypolicy
redistributeswealth.Appropriatemonetarypolicycanmitigatedebtoverhangdistortions.Thisstabilizes
theeconomy,reducesendogenousrisk,andcanspurgrowth,raisingtheoverallwealthlevelinthe
economy.Forspecificscenarios,monetarypolicycanevenleadtoexpostParetoimprovements,
makingallagentsintheeconomybetteroff.
ThiswealthredistributionchanneldiffersfromthetraditionalKeynesianinterestratechannel.Inthose
models,thekeyfrictionisduetopricestickiness,notfinancialfrictions.Assuch,loweringthenominal
interestratelowerstherealinterestrate.Alowerrealinterestratestimulatesaggregateconsumption
andinvestmentastherepresentativeagentbringsconsumptionforward.InmostNewKeynesian
models,theinterestratesaresetbyarule,e.g.,theTaylorrule,andmoneyservesonlyasaunitof
account.Thezerolowerboundofthenominalinterestratelimitstheeffectivenessofconventional
monetarypolicy.
Ingeneral,conventionalmonetarypolicyfocusesprimarilyontheshortendoftheyieldcurve.
Expectationsaboutfuturepolicyindirectlyaffectthelongendoftheyieldcurve.Unconventional
monetarypolicydirectlytargetsthelongendoftheyieldcurveandpricesofspecificassets.Allthese
measurescanredistributewealthacrossandwithinsectors.Forexample,wefindthatadeclineofthe
10yearinterestratethatwidensthe25 to10yeartermspreadhurtslifeinsurancecompaniesand
pensionfunds.
Centralbanksalsoassumetailrisk.Theytransferriskawayfromtheprivatesectors.Moreprecisely,
centralbanksredistributetailrisktomanynominalclaimholdersacrosstheeconomy.Theredistribution
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ofriskisawealthredistributioninthefuturecontingentonspecificfuture(tail)events.Forexample,
purchasesofriskyassetsredistributeriskoftheultimatepayoffoftheseassetstoallnominalclaim
holdersintheeconomy.Centralbanksthatrelaxcollateralrequirementsforlendingprogramsinsure
againstthetaileventinwhichtheborrowerandthecollateralfailtocovertheborrowedamount.
Importantly,theredistributionofriskisnotazerosumgame.Mostoftheriskintheeconomyis
endogenousi.e.,self
generated
by
the
system.
Hence,
appropriate
monetary
policy
can
reduce
the
overallriskintheeconomy.
Moregenerally,monetarypolicy(rules)canbeseenasastabilizingimplicitsocialinsurancescheme
acrossagentsandsectorsforeconomiesbesetbyfinancialfrictions.Essentially,monetarypolicy
(partially)completesmissingmarkets.Theefficiencygainsarelargestwhenexogenousriskissmalland
selfgeneratedendogenousriskislarge.Thelatteristhecasewhentheproductivityorvaluationgap
betweennaturalholdersandsecondbestholdersofassetsislarge.Withalargegap,firesalesfromthe
naturalholdersofassetstoothersleadtolargepricemovementsamplifiedbyliquidityanddeflationary
spirals.Formonetarypolicytoworkasasocialinsurancescheme,thecentralbankhastofollowand
clearlycommunicate
an
ex
ante
well
specified
policy
rule.
Aswithanyinsurancescheme,monetarypolicycomesatthecostofmoralhazard.Tokeepmoral
hazardcostsundercontrol,thedesignoftheredistributionschemeiscrucial.Forexample,if
recapitalizationeffectsofmonetarypolicyareproportionaltothebanksnetworthi.e.,thepolicy
helpsstronginstitutionsmorethanweakonesthencompetitioninnormaltimeswithinthesector
keepsmoralhazardincheck. Ofcourse,supportingstrongerhealthybanksintimesofcrisisisexpost
morecostly.Exante,however,thiscommitmentmakesmonetarypolicylesspronetomoralhazard
comparedtomoretargetedpolicyinstrumentsthatsubsidizetheweakinstitutions.
Generally,theintentofamonetarypolicyruleistoaffecttheeconomicagentsbeliefsandbehaviorin
orderto
steer
the
economy
toward
the
socially
desirable
objective.
Asymmetric
information
problems,
suchasmoralhazard,limittheeffectivenessofsuchrulesandconstrainthesetofimplementablerules.
Inotherwords,systemicfinancialinstitutionscanunderminesomedesirablerulesandmayevenbeable
toforcethecentralbanktoabandonitsrulebook.Redistributivemonetarypolicyshouldbestrictly
limitedtoundoingtheredistributioncausedbytheamplificationeffectsandbymoralhazard
considerations.
Untilrecently,thepredominantviewwasthatthethreeobjectivesofpricestability,financialstability,
andfiscalgovernmentdebtsustainabilitycanbetreatedindependentlyfromeachotherandassigned
separatelytomonetary,regulatory,andfiscalauthorities,respectively.Thisviewfailstoseethatthe
centralbank
can
be
cornered
by
financial
institutions
and
fiscal
authorities.
Fiscal
authorities
will
try
to
forcethecentralbanktomonetizegovernmentdebtinordertoavoidpoliticallyunpopularausterity
measures.Incrisissituations,centralbanksmightfacetheunpleasantchoicebetweenfiscaldominance
withassociatedinflationorgovernmentdebtdefault.Thepurepossibilityofgovernmentdebtdefault
leadstoadiabolicloopbetweensovereignriskandbankingrisk.Assovereigndefaultprobabilityrises,
bankssufferlossesandcutbacktheirlending.Thisslowsdownthegrowthoftherealeconomyaswell
asthetaxrevenueforthesovereign.Atthesametime,abailoutofbanksmightbecomemorelikely.
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Overall,intimesofcrisis,opposingdeflationaryandinflationaryforcesarestrongandbalancingthem
becomeschallenging.Theeconomyisveryunforgivingtoevensmallmistakes.Itcaneasilydriftofftoa
deflationaryorinflationarytrajectory.
Topreempttheseforcesfromtakingover,forwardlookingmonetaryandmacroprudentialpolicyhasto
incorporateearly
warning
signals
about
the
potential
buildup
of
systemic
risk.
Low
volatility
environmentsandfinancialinnovationsareconducivetosuchabuildup.Simplemeasuresofdebtto
GDPratioandleverage,ormoresophisticatedliquiditymismatchmeasuresacrosssectors,are
indicatorsofvulnerability.
Thenextsectionofthispaperpresentssomesummarystatisticsandoutlinessomesimpleempirical
observations.Sincedataforcounterfactualscenariosaresparse,themainpartofthepaperrelies
heavilyontheoreticalreasoning.Variouspolicymeasuresareanalyzedthroughthelensoftworecent
theoreticalpapersbyBrunnermeierandSannikov(2011,2012),referredtoasBruSanhereafter.Both
thesepapersbuildonearlierworkonfinancialfrictionsinthemacroeconomybyBernankeandGertler
(1989),KiyotakiandMoore(1997,2011),andBernanke,Gertler,andGilchrist(1999).Foradetailed
surveyoftheexistingliterature,wereferreaderstoBrunnermeier,Eisenbach,andSannikov(2012).
2.APreliminaryLookattheDataWestartwithsomestylizedobservationsbeforeconceptualizingtheredistributiveeffectsofvarious
amplificationmechanismsandstudyingpolicyresponsestothem.Followingearlierworkbyeconomists
likeArthurBurnsandWesleyMitchell,CooleyandPrescott(1995)characterizestylizedfactsofbusiness
cycleswithoutmakingmuch,ifany,referencetofinancialvariablesordebtlevels.
Becausefinancialfrictionslimittheflowoffunds,thedistributionofwealthandagentsriskbearing
capacityare
of
huge
relevance
for
the
efficient
allocation
of
economic
resources.
Highleverageexposeseconomicagentstosuddenshiftsinwealth.Therefore,wefirstreportdebtto
GDPratiosacrossvarioussectors.DebttoGDPpermitsabettercrosssectionalcomparisonthanwould
debttoequity.Amongflowvariableswefocusondebtserviceburdenmeasures.Peoplewithhighand
variabledebtserviceburdenaremorevulnerabletocashfloworliquidityshortages. However,looking
atthesemeasuresbasedonexistingdatagivesusonlyaroughguideline.Amoreadvancedapproach
wouldinvolvelookingatrisktopographyandliquiditymismatchacrossvarioussectorstocapturethe
endogenousresponsesandfeedbackloops.2
Asasecondstep,wewouldlikesomeideaofhowmonetarypolicyhelpsmitigateredistributional
effectsduringtherunuptoandinfinancialrecessions.Thisis,ofcourse,anevenmorechallengingtask
2Forexample,Brunnermeier,Gorton,andKrishnamurthy(2012,13)proposetoelicitfromeachfinancialfirmits1)
valueexposureand2)liquidityexposuretochangesinkeyriskfactorsandscenarios.Thisinformationcanbefed
intoageneralequilibriumframeworktodeterminetheimpactofkeyrisksonassetprices.
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becausepolicyresponsesareendogenous.Wedonotobservewealthshiftsthatwouldhaveoccurredin
acounterfactualworldwithoutpolicyreaction.
Thefirsttaskistoselecttherightgroupingintosectors.Indeed,thewholeanalysisdependsonthe
classificationandclusteringofvariouseconomicagents.Theoptimalclusteringdependsonthe
economicquestion
and
the
availability
of
data.
To
begin,
we
follow
the
classic
sector
analysis,
which
dividestheeconomyintoahouseholdsector,nonfinancialbusinesssector,financialsector,and
governmentsector.Thisgroupingintosuchlargesectorsremovesasignificantquantityofintrasector
debtthroughnettingofoffsettingloans.Ofcourse,aggregatetotaldebtinaclosedeconomyiszero.To
furtherouranalysis,wetakeacloserlookatthefinancialsectoranddisaggregateitintovarious
subsectors.Thissectorisofparticularinterestasitliesatthecenterofmanybalancesheetrecessions.
2.1DebtandLeverage
Figure1:DebttoGDPratiosforseveralsectorsovertimeintheU.S.(PanelA)andJapan(PanelB).NBER
recessionsarerepresentedasshadedcolumns.
Figure1depictsthedebttoGDPratiosforthekeysectors.PanelAshowsthedebtratiosfortheUnited
States,andPanelBisthecorrespondinggraphforJapan.NBERdesignatedrecessionsarerepresented
asshaded
lines.
PanelAclearlydocumentsthattheoveralldebtlevelintheU.S.economyhasincreasedsignificantly
overtime.Thefirstobservationwecandrawfromthedataisthatnotallrecessionsarethesame.From
1960to1985,thedebttoGDPratiosofthemainsectorschangedverylittle.Forexample,therecession
in1980wasnotprecededbyanexpansionofdebtandwasinducedbytheFederalReservestightening
ofmonetarypolicytoconquerinflation.
0%
50%
100%
150%
200%
250%
300%
350%
1962
1966
1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
2010
0%
100%
200%
300%
400%
500%
600%
700%
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
2009
Government
FinancialInstitutions
Households
Corporates
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Intherecessionoftheearly1990s,afterthesavingsandloan(S&L)crisis,thenonfinancialbusiness
sectorreduceditsdebtlevel.Itisdifficulttodrawmoredetailedconclusionsfromthenonfinancial
businessdebttoGDPtimeseries(bottomarea).Indeed,thetemporaryreductionofnonfinancial
businessdebtduringtheGreatRecessionisconsistentwiththeempiricalfindingthatthissector
significantlyexpandeditscashholdingsevenbeforethecrisis,asdocumented,forexample,inBates,
Kahle,and
Stulz
(2009).
ThehouseholddebttoGDPratiosteadilyincreasesfromthemid1980sonwards,despitethebursting
oftheInternetbubblein2000andtheassociatedrecession.ThesharpdropfollowingtheGreat
Recessionisstriking.Householdssignificantlyreducedtheirspendingandincreasedtheirsavingsin
ordertorepairtheirbalancesheets.Apartofthedeclinecanbeattributedtodefaultsonmortgage
debt,whichinducedlossesinthebankingsector.Financialsectordebtalsorosesteadily,althoughit
recordedasmalldeclineduringtherecessionoftheearly1990s.Governmentdebtdeclinedduringthe
ClintonyearsandsignificantlyincreasedduringtheGreatRecessionessentiallyreplacingdeclining
householddebt.
Observation1:Notallrecessionsarethesame.Somerecessionsareprecededbyarunupindebtand
thenaccompaniedbyasubsequentdecline,butothersarenot.
PanelBdepictsthesamegraphforJapan.PriortoJapanslostdecades,assetpriceappreciationwas
evenhigherinJapanthanintheUnitedStatesinthe2000s. PanelB,however,clearlyshowsthatin
Japanthenonfinancialbusinesssector,nothouseholds,builtuplargeamountsofdebtinthe1980s.
From1990onwards,thenonfinancialbusinessdebttoGDPratiohasremainedroughlyconstantasthis
sectorsbalancesheetshavebeenunderrepair.Fromlate1996onwards,thisdeleveragingaccelerated
andthenonfinancialbusinessdebttoGDPratiodeclinedforseveralyears.
Interestingly,1997
corresponds
to
the
peak
in
nominal
GDP,
and
that
year
can
be
seen
as
the
transition
fromadeeprecessiontoasustainedstructuralslump.In1996,8.0trillionyenofassetsweretiedupin
bankruptcyproceedings.By1997,thisnumberhadjumpedto14trillionyen(seeHamada,Kashyap,and
Weinstein(2011)).Incontrast,thehouseholdsectorsdebtlevelexperiencedonlyamarginalincrease
overtheseyears,withasmallslowdowninthefirstfewyearsof1990s.The1997watermarkrecessionis
almostundetectableinthetimeseriesofhouseholddebt.
King(1994)studiedrecessionsinearly1990acrossmanycountries.Hedocumentsthatcountrieswith
thelargestincreaseinprivatedebtfrom1984to1988experiencedthedeepestshortfallofgrowthin
theperiodfrom1989to1992.ThisevidenceandthecontrastbetweenPanelsAandBleadtothe
second
observation.
Observation2:Notallbalancesheetrecessionsarethesame;differentsectorscanbeinvolved.
AnotherdifferencebetweentheJapaneseandU.S.crisesistheextenttowhichforeigncreditflowwas
involved.Hence,methodsforpreventingfinancialrecessionsmightalsodiffer,dependingonwhich
sectorssufferfromdebtoverhangproblems.
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Finally,intheUnitedStatesaswellinJapan,financialrecessionsledtohighergovernmentdebt.
Observation3:Governmentdebtinacrisisoftenincreasesbymorethanthecombineddecreasesin
householdandnonfinancialbusinessdebt.
Figure1groupsallhouseholdstogether.However,householdsdebtexposureandrealestateholdings
varyalotwiththeirageandskilllevel.Consequently,interestratesandinflationcanleadtolarge
wealthshiftswithinthehouseholdsectoracrossdifferentagecohorts.
MianandSufi(2009)usemicroeconomichouseholddataacrossU.S.countiestoshowthattherisein
householdleverageduringthecreditboomwasastrongpredictorofrecessionseverityfrom2007to
2009.Countiesthatexperiencedthelargestincreaseinhouseholddebtbeforetherecession
subsequentlysawlargerincreasesinunemploymentandlargerdecreasesinresidentialinvestmentand
durableconsumption.
Theredistributionaryeffectsofinflationhavelongbeenrecognized(see,e.g.,Keynes(1923)).Itisuseful
todraw
adistinction
between
anticipated
and
unanticipated
inflation,
as
emphasized
in
Kessel
and
Alchian(1962).ManystudiesfocusontheU.S.GreenbackerafollowingtheU.S.CivilWar(see,e.g.,
FriedmanandSchwartz(1963))orWeimarinflation(see,e.g.,BrescianiTurroni(1937)).Morerecently,
DoepkeandSchneider(2006)provideadetailedandcomprehensivestudyofredistributionaleffectsof
inflationacrossdifferentagegroupswithintheUnitedSates.Coibionetal.(2012)studytheimpactof
monetarypolicydecisionsonconsumptionandincomeinequality.Theyarguethatcontractionary
monetarypolicyincreaseslaborincomeinequality.
Sofar,ourfocushasbeenprimarilyondebt,but,ofcourse,onepersonsdebtisanothersfinancial
asset.3Nonfinancialclaimsonrealprojects,property,andphysicalcapitaldifferinthattheyarenot
related
to
liabilities.
The
present
real
value
of
most
of
these
assets
depends
on
current
and
future
interestandinflationrates.Inflationsurprisescanerodethevalueoflongdatednominalclaims.The
differencebetweenassetsandliabilities,i.e.,networthorwealth,ofasectorshiftsaroundacrosstime.
Ultimately,allclaimsareheldbyhouseholds.Forexample,firmswealth(equity)isownedbyits
shareholders.Whendefiningwealthshares,itisimportanttoassignwealthtothosesectorsthatarein
controlofresources.Inthissetting,itisclearthatcorporateexecutives,nothouseholds,possessthe
decisionmakingcapitalbackedbythisequity.Whenviewedfromthisperspective,itbecomesapparent
thatflowsareimportantaswell.
2.2DebtServiceBurden
Sofar,
we
have
focused
on
stock
variables
whose
value
might
appreciate
or
depreciate
as
events
unfold.
Toaddressliquidity,wemustalsoconsiderflowvariables,suchascashflows.Here,wefocusondebt
serviceburdens.
3Indeed,whencalculatingthenetliabilitiesofthebankingsector,wesimplyaddedupthefixedincomeclaimsby
theothersectors(includingtheforeignsector).
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Forthehouseholdsector,theFederalReserveprovidesthehouseholddebtserviceratio(DSR),whichis
anestimateoftheratioofdebtpaymentstodisposablepersonalincome.Debtpaymentsconsistofthe
estimatedrequiredpaymentsonoutstandingmortgageandconsumerdebt. Thefinancialobligations
ratio(FOR)simplyaddsleasepayments,rentalpayments,homeownersinsurance,andpropertytaxes.
Theseratioscanbehighfortworeasons:high(real)interestratesorhighdebtlevels.Alowinterest
rateenvironment
is
associated
with
high
house
prices
and
thus
high
debt
levels.
This
explains
why
the
financialobligationsratioforhouseholdsinFigure2isrelativelystable.
Figure2:
Household
financial
obligations
ratio
compared
to
relevant
interest
rates.
Top
to
bottom
(leftaxis):Householdfinancialobligationsratiocontrolledforpricetorent;(noaxis):pricetorentratio;
(rightaxis):30yearmortgagerate;threemonthTreasurybillrate;Michiganinflationexpectations.
Observation4:Forthehouseholdsector,adeclineinthemortgageratehastwoeffects.First,as
householdscanrefinancemortgagesatlowerrates,thedebtserviceratiodeclines.Second,lower
interestratesleadtohigherhouseprices,andhouseholdstakeoutlargermortgagestofinancetheir
houses.
Inotherwords,thedebtserviceratioshouldbeproportionaltotherealinterestratetimesthedebt
level
(or
house
prices).
To
separate
the
direct
from
the
indirect
effect,
we
regress
the
log
of
the
debt
serviceratiotothelogoftherealinterestrateplusthelogofthepricerentratio.WeusetheFHFA
HomePriceIndex.Theregressionyieldsthefollowingcoefficients:
LogFORatio LogReal30yMtg.Rate LogPricetoRent Constant
Coefficient 0.0227 * 0.3697 *** 1.7486 ***
StandardError 0.0101 0.0603 0.0296
Rsquared 0.6045
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
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Table1:Logfinancialobligationratioregressedonlogreal30yearmortgagerateandthelogpriceto
rentratio.*refersto5%,**to1%,***to.1%statisticalsignificance.
ThelowerpartofFigure2depictsthereal30yearmortgagerateandtherealthreemonthTreasury
rate.Togetrealrates,wesimplysubtracttheexpectedinflationrateasmeasuredbytheMichigan
survey.The
colored
area
between
both
rates
reflects
the
spread
between
them.
The
chart
confirms
the
empiricalfindingthatlowinterestratesareassociatedwithhighhousepricetorentratiosandtheFOR
controlledforthehousepriceeffectpositivelycommoveswiththe30yearmortgagerate.
Figure2showsthedebtserviceburdenforhouseholds.Twoaspectsareworthemphasizing.First,the
debtserviceburdenrisesmoderatelyfrom1995onwards.Relativetotheoverallincreaseofhousehold
debt,theincreaseindebtserviceburdenhasbeenmodestbecauseofthedeclineininterestrates.
Morepronouncedisthesharpdropofthedebtserviceburdenfrom2008onwards.Thissharpdeclineis
duetothedeclineindebtandthedropininterestratesthateasedthefinancialconstraintson
households.
Forthe
non
financial
business
sector,
we
conduct
asimilar
exercise.
We
consider
the
interest
expense
as
afractionofearningsbeforeinterest,taxes,depreciation,andamortization(EBITDA).Thedataarefrom
CompuStat,takingtheratioacrosstheaggregatesectorexcludingfinancialfirms,insurancecompanies,
andrealestate(SICCodes60xx,61xx,62xx,63xx,64xx,65xx).
Observation5:Debtserviceburdenforthenonfinancialcorporatesectorispositivelyrelatedtothe
interestrateandthespreadbetweentheMoodyscorporateBAAindexandthethreemonthTreasury
interestrate.
FortheregressionofthedebtserviceburdenontherealthreemonthTbillrateandtherealcorporate
BAA
credit
spread,
the
positive
coefficient
on
the
spread
is
highly
significant
at
a
0.11%
level.
InteresttoEBITDA Corporate 3mTsy Real3mTsy Constant
Coefficient 1.2067 ** 1.4499 *** 0.1169 ***
StandardError 0.3597 0.2538 0.0183
Rsquared 0.5298
Table2:NonfinancialbusinessinteresttoEBITDAratioregressedontheCorporateBAAindexspread
overthethreemonthTreasuryrate.
2.3ACloserLookattheFinancialSector
Apartfromitsroleinmanybalancesheetrecessions,thereareseveralotherreasonstosplitupthe
financialsector.
First,
the
funding
flow
within
the
financial
sector
is
large.
By
simply
aggregating
all
financialfirmsandnettingoutexposures,wemisssystemicriskandamplificationmechanismsthatarise
withinthefinancialsector.Second,riskexposuresofdifferentgroupsinthefinancialindustrydiffer
significantly.Forexample,commercialbanksareactiveinmaturitytransformation,whilelifeinsurance
andpensionfundshavecomplementaryexposuretoyieldcurvechanges.Third,differentaccounting
rulesmakeitdifficulttocomparedifferentfinancialindustries.Whilemostassetsofinvestmentbanks
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aremarkedtomarket,forcommercialbanksonlythesmallertradingbook(andnotthebankingbook)
followsmarketprices.Differencesinaccountingrulesaffectnotonlydata,butalsofirmsbehavior.
Wegroupfinancialfirmsintocommercialbanks,bankholdingcompaniestogetherwithinvestment
banks,shadowbankinginstitutions,governmentagencies,insurancecompanies,andpensionfunds.
Traditionalcommercialbanksdebtconsistsprimarilyofdemanddeposits,CDs,interbankmarket
funding,andfundingfromtheirbankholdingcompanies(BHCs).Bankholdingcompaniesissuelong
termbonds,mediumtermnotes,and(financial)commercialpaper.SomeBHCsarealsoactiveinthe
investmentbankingbusiness. AfterLehmansfailureinSeptember2008,alllargeinvestmentbanks
becameBHCs. Hence,wegroupBHCswithinvestmentbanksthathavebrokerdealerbusinesses.
BHCsandinvestmentbankshavenetrepoliabilitiestothenonfinancialbusinesssectorandthe
householdsector. Corporationsusetherepomarketlikeacheckingaccounttoholdshorttermfunds.
Theyalsoinvestalongwithhouseholdsinmoneymarketfundsandotherbondfunds.
Moneymarket
funds
are
part
of
the
(less
regulated)
shadow
banking
system.
Money
market
funds
investinvariousothershadowbankinginstitutionsandstructuredvehicles,suchassecuritized
mortgagepools,autoloans,andcreditcardreceivables.Whilemanyobligations(includingrepos)net
outwithintheshadowbankingsector,shadowbankinginstitutionsalsoholdlongtermdebtofBHCs
andinvestmentbanks. PriortotheGreatRecession,BHCsobtainedcheapsecuredfundingsincethey
couldrehypothecatetheircustomerscollateralatfavorablehaircuts.Theirsecuritieslendingactivityis
partofthisactivity.
GovernmentagencieslikeFreddieMacandFannieMaewerelargeplayersinsecuritizationoften
simplybypooling(qualified)mortgagesandissuingagencybonds.TheU.S.governmentinitially
implicitly
guaranteed
and,
since
July
2008,
has
explicitly
guaranteed
these
agency
bonds.
Welookseparatelyatinsurancecompaniesandpensionfundssincethematuritystructureoftheir
assetsandliabilitiesisdifferentfromthatoftraditionalandshadowbanks. Insurancecompaniesand
pensionfundshavelongdatedliabilities.Hence,changesintheyieldcurveaffectthemverydifferently
fromtherestofthefinancialsector.
Overall,itisdifficulttofindreliablemeasuresofthesesectorsdebtobligations.Thisisespeciallytrue
fortheshadowbankingsector.Manyentities(suchashedgefunds)donotreporttheirholdingsand
liabilities. Anotherproblemisthedoublecountingofdebtwithinasectorastheintermediationchain
grows. ThisdoublecountingexplainsalargepartofthegrowthoffinancialinstitutionsdebtinFigure1.
Foreignbanks
that
are
active
in
the
U.S.
also
complicate
the
picture.
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Figure3:DebttoGDPratioofcommercialbanks,shadowbanks,governmentsponsoredenterprises,
andbankholdingcompaniesincludinginvestmentbanks.NBERrecessionsarerepresentedasshaded
columns.
Figure3illustratesthedebtlevelsofvariouscomponentsofthefinancialsector.Comparedtotheresult
showninFigure1,thedebttoGDPratioofthetotalfinancialsectorisnowhigher,sincedebt
obligationswithinthelistedfourfinancialsectorgroupsarenotnettedoutinFigure3.
Thegeneraltrendisasteadyandfastriseinshadowbanking,partlyattheexpenseofthetraditional
bankingsystemfromthe1980sonwards. Duringthatperiod,thefollowingeventsoccurred:1)BaselI
createdincentivesforsecuritization,and2)interestrateregulationfavoredmoneymarketfunds. Atthe
sametime,ITinnovationsmadecollateralmanagementforrepomarketseasier.
DuringtheS&Lcrisisinthe1980sandearly1990s,theburgeoningshadowbankingsectoronlypartly
compensatedfortheslowdownintraditionalbankingactivity.However,financialsectorliabilitiesgrew
atonlyamoderatepacepriortotheS&Lcrisis.
Thisresultisinstarkcontrasttothebeginningofthecurrentfinancialcrisis,whereweobservedasharp
dropinshadowbankingactivityinthesecondhalfof2007. TheinitialdropoccurredasABSissuance
andtheABCPmarketfrozeup.Interestingly,thisdropwasmorethanoffsetbyanexpansioninactivity
bythegovernmentsponsoredenterprises(GSEs)andFederalHomeLoanBank.AcloserlookatFigure3
alsohighlightstherolethatGSEsplayedintheearlypartofthecrisis.InJuly2008,thedebtof
governmentagenciesbecameexplicitgovernmentdebtanditseemsthattheGSEslosttheirmoderating
0%
50%
100%
150%
200%
250%
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
BankHoldingCompany
NetGSE
NetShadowBanking
TraditionalBanking
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role.TherealcollapseoftheshadowbankingsystemfollowedthedemiseofLehman. Atthatpoint,
investorsfledtoFDICinsureddemanddeposits,leadingtoanincreaseintheliabilitiesoftraditional
banksatthattime.Foramoredetaileddescriptionoftheseevents,seeBrunnermeier(2009).
Interestmovementscanaffectthevalueofassetsandliabilitiesoffinancialinstitutionsandalsoaffect
futureearnings.
Different
parts
of
the
financial
industry
are
sensitive
to
different
parts
of
the
yield
curve.Hence,nonconventionalmonetarypolicythattriestotargetthetermspreaddirectlyhas
differentredistributionalconsequencesthanasimplereductionintheshortterminterestrate.
ForcommercialbanksandBHCs,datafromCallReportsallowustosplitnetincomeintonetinterestand
netnoninterestincome.Accountingrulesplayanimportantroleintheregressionspecification.Ifassets
aremarkedtomarket,thenaninterestratecutthatsteepenstheslopeoftheyieldcurveleadstoan
immediatecapitalgainreportedasanincreaseinnoninterestincome.Ontheotherhand,iftheposition
isnotmarkedtomarket,anincreaseinaninstitutionsprofitabilitythroughhighernetinterestmargins
showsuponlywithalaginthenetinterestincomelineitem.
Adetailed
study
of
the
effects
of
interest
rate
changes
on
bank
stock
returns
and
income
can
be
found
inEnglish,VandenHeuvel,andZakrajsek(2012). Here,wereportasectionofTable8fromtheirpanel
regressionresults.
NetInterestIncome NoninterestIncome NetIncome
3mTsy 0.088 *** 0.015 0.051 ***
(StdError) 0.014 0.011 0.010
10y 3mTsy 0.071 *** 0.005 0.037 ***
(StdError) 0.011 0.008 0.008
Rsquared 0.690 0.321 0.258
Table3:
This
table
reports
three
income
to
asset
ratios
regressed
on
level
and
slope
of
the
yield
curve
andvariousothercontrols.ThetableisanexcerptofTable8inEnglishetal.(2012).
Intheirstudy,Englishetal.considerthreeincomemeasuresnormalizedbyassetsandregressthemon
maturitygap,otherassets,otherliabilities,savingsdeposits,demanddeposits,loans,andbanksizeall
interactedwithlevelandslope;theregressionsalsoincludelevelandslopeasindependentregressors
andfourlagsofincome.
Thefirstrowofregressioncoefficientsshowsthatanupwardparallelshiftoftheyieldcurveis
associatedwithhighernetinterestandnetincomeoverassets.Thereareatleasttworeasonsforthis
result.First,astheinterestrateincreasesthevalueofassetsdropsfasterthantheincome.Indeed,the
authorsshowthatchangeinlogassetsissignificantlynegativelyrelatedtopositiveshiftsinlevelofthe
yieldcurve. Second,thisresultcouldbesimplydrivenbythefactthattheleveloftheyieldcurveishigh
wheneconomicgrowthishigh.Thatis,athirdomittedfactorcouldbedrivingtheseresultswithoutany
directcausallinkbetweentheleveloftheyieldcurveandtheprofitabilityofbanks.
Moreinterestingforourpurposesisthecoefficientonthetermspreadbetweenthe10yearTreasury
bondandthethreemonthTreasurybillrate.Banksaretypicallyactiveinmaturitytransformation,and
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theirnetinterestincomeandnetincomerisewiththetermspread.Noninterestincomeshowsno
significantchange.
Tocontrolfortheendogeneityoftheseinterestratechanges,Englishetal.lookatsurpriseinterestrate
movementsrelativetothepredictionsfromthefedfundsfuturesmarket.Bankstockpricesfall
followingan
unanticipated
rise
in
the
level
of
the
yield
curve.
They
also
fall,
however,
with
an
unanticipatedsteepeningoftheyieldcurve.
Ontheotherhand,Begenau,Piazzesi,andSchneider(2012)findthatthebigfourBHCsbenefitfrom
interestratecuts.Thispaperassumesatwoyearswaprateasasinglefactor,sothatallrisks,even
defaultrisk,canbereplicatedwithacombinationofalongmaturityrisklesspublicbondandcash.
Withintheirframework,theyfindthatbanksaregenerallyshortcashandlongtherisklessbond.Instead
ofusinginterestratederivativestohedge,theseBHCsamplifytheirinterestrateexposure.
Insum,whileaccountingvariablesshowapositivecorrelationbetweenbankinterestnetincomeand
theslopeoftheyieldcurve,evidenceusingstockmarketdataismixed.
Observation6:NetincomemeasuresforBHCsarepositivelyrelatedtothetermspread.
Thematuritystructuresoflifeinsurancecompaniesandpensionfundsdifferfromthoseofbanks.Their
liabilitiesareverylongterm,oftenupto30years.Sincethesetoffixedincomeinstrumentswithsuch
longmaturityislimited,theirassetsareofshorterduration.Figure4indicatesanegativerelationship
betweenthe25yearto10yearTreasuryspreadandlifeinsurancecompaniesnetincome.
Figure4:Lifeinsurancecompaniesnetincomecomparedtorelevantinterestrates.
Toptobottom(leftaxis):Lifeinsurancenetincomeoverassets;
(rightaxis):25yearTbond;10yearTnote;threemonthTbill;Michiganinflationexpectations.
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
3.00%
2.00%
1.00%
0.00%
1.00%
2.00%
3.00%
1978 1985 1992 1999 2006
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Lifeinsurancecompaniesarenotsubjecttospecialaccountingrules,andtheydontmarktheirpositions
tomarket.Hence,anychangeinthe25 to10yeartermspreadwillrequiresometimetoshowupinthe
netincomenumbers.
InsuranceNI/Assets 25y10y(3) 25y10y(2) 25y10y(1) 25y10y Real3mTsy Intercept
Coefficient 0.8454* 0.2028 0.2368 0.4622 0.1158* 0.0109***
StandardError 0.3570 0.4318 0.4288 0.4801 0.0604 0.0029
Rsquared 0.6552
PensionFundingStatus 25y10y(2) 25y10y(1) 25y10y Real3mTsy Intercept
Coefficient 16.9382* 2.1253 13.1257 7.5868*** 0.0483
StandardError 7.5490 9.3954 10.6505 1.4540 0.0644
Rsquared 0.8054
Table4:PanelAreportstheregressioncoefficientsofleveloflifeinsurancecompaniesnetincometo
assetratioonthecontemporaneousandlaggedlevelofthe25 to10yeartermspreadandshortterm
realinterestrate.PanelBreportsthecoefficientsforthedifferenceinpensionfundingstatus.
InTable4,PanelAreportstheregressioncoefficientofnetincomeoverassetsonthe25 to10year
termspreadwithvariouslagsandtheshorttermrealinterestrate.PanelBrepeatstheexerciseforthe
fundingstatusofpensionfunds.
Upwardparallelshiftsoftheyieldcurveboostthenetincomeofinsurancecompaniesandthefunding
statesofpensions.However,awideningofthe25 to10yeartermspreadtendstohurtslifeinsurance
companiesand
pension
funds.
Observation7:Whileforbanksthe10yeartothreemonthtermspreadwasmorerelevant,forlife
insurancecompaniesandpensionfundsthelongerendoftheyieldcurve,i.e.,the25 to10yearterm
spread,mattersmost.
Sofar,wehaveignoredtheimportantinterplaybetweenfundingliquidityontheliabilitysideand
marketliquidityontheassetsideofbalancesheets.Thenextsectionsprovidetheconceptual
underpinningsofdeeperanalysisandexplaintherolethatmonetarypolicycouldplaytomitigate
redistributionalamplificationeffects.
3.TheThreePhasesofFinancialRecessionsThissectionprovidesatheoreticalframeworkbywhichfinancialrecessioncanleadtowealth
redistributions.Withouttheory,itisimpossibletointerpretthestylizedobservationsmadeabove.The
regressionslinkingexpenseorincomestatementswithinterestratesareespeciallyplaguedby
endogeneityproblems.Interestratesarea(monetary)policyinstrumentandrespondtotheeconomic
environmente.g.,tolossesinthefinancialsystem.
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Financialrecessionsaretypicallyprecededbyaperiodofincreasingimbalances,boomingassetprices,
andgrowingcredit.Thesubsequentfinancialrecessionsetsinmotionanumberofamplification
mechanisms,whichoftenleadtosignificantandpersistentreductionsineconomicactivity.Recovery
afterfinancialrecessionscanbeslowinlargeadvancedeconomies.
3.1Boom
Phase:
The
Run
up
Financialrecessionsstemfromtheearlierbuildupofsystemicriskintheformofunsustainable
imbalancesandbubbles. Theaccumulationoftheseimbalancescanbeattributedtoincentiveand
beliefdistortions.Incentivedistortionsarisefrommoralhazardproblemscausedbyexpectedbailout
policiesorsimplybecausemarketparticipantsfailtointernalizefiresaleexternalities.Forexample,
whenleveringupwithshorttermdebt,eachspeculatortakesintoaccountonlythathemightnotbe
abletorolloverhisdebtandmightbeforcedtoselloffassetsatfiresaleprices.However,thesame
investordoesnottakeintoaccountthathissellingwilldepressprices,potentiallyforcingotherstosell
aswell. Putdifferently,financialstabilityisapublicgoodandeachindividualtraderscontributionisless
thansociallyoptimal.
Inadequatedataandanecdotalevidenceofthistimeisdifferentthinkingmakeitdifficulttoruleout
beliefbiases.Initially,boomscanberationalizedbyappealingtosomeformofinnovation.This
innovationcouldbetechnologicalchange(e.g.,railroads,telegraph,theInternet),financialliberalization
(e.g.,theremovalofRegulationQ),orfinancialinnovation(e.g.,securitization).
However,astheimbalancesandbubblesgainmomentum,itultimatelybecomesclearthatthe
fundamentalimprovementsthatmayhavewarrantedaninitialincreaseinassetpricescannotkeepup
witheverincreasingvaluations.Eventhoughsomemarketparticipantsarepronetoextrapolative
expectations,thequestionofhowsuchimbalancescanbuildupforsolongandwhatpreventsrational
investorsfromcorrectingthemsoonerremains.
Oneansweristhatindividualrationalmarketparticipantsfinditmoreprofitabletoridethetrendrather
thanleanagainstitaslongasthemusicisplaying.Inasettinginwhichacorrectionoccursonlyaftera
sufficientlylargenumberofmarketparticipantschangecourse,eachindividualwaitsforotherstomove.
AbreuandBrunnermeier(2003)modelthissynchronizationproblem. Marketparticipantssequentially
receiveasignalthatthecurrenttrajectoryisunsustainable.Eachmarketparticipantweighsthegain
fromridingthetrendagainsttheriskofbeingcaughtintheinevitablecollapse.Inequilibrium,large
imbalancesbuildupasagentsinitiallychoosetoridethetrend,andthecorrectionoccursonlyaftera
significantdelay.Themainproblemisthatthenecessarycorrectionoftenoccursafterlargeimbalances
havealreadydeveloped.
Boomsfueledbycreditdeservespecialattention,sincetheburstingofcreditbubblesleadstomore
deleveragingandstrongeramplificationmechanisms.Forexample,whiletheburstingofthetechnology
bubblein2000triggeredsignificantwealthdestruction,itsimpactontherealeconomywasrelatively
mildincomparisontotheGreatRecession.ThedistinguishingfeatureoftheGreatRecessionwasthe
precedingcreditboom.Similarly,therunupinstockpricesduringtheRoaringTwentieswastoalarge
extentbasedoncreditintheformofmargintrading,i.e.,itwasfinancedviashorttermloans.This
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creditfedboomultimatelyledtotheGreatDepression.Likewise,theScandinaviancrisisintheearly
1990sandtheJapaneselostdecadewerealsoprecededbylendingboomsthathadledto
unsustainableassetprices.
Thecoreofouranalysisandpolicyrecommendationsisderivedfromtheframeworkdevelopedin
BrunSan(2011,2012).
We
sketch
the
details
and
main
implications
in
the
next
section,
but
will
highlight
heretwoimportantresultsthatdirectlyrefertotherunupphase:
1. volatilityparadox2. destabilizingfinancialinnovation
Thevolatilityparadoxreferstothephenomenonthatareductioninexogenousrisklevelmakesthe
systemmorepronetowardsystemicvolatilityspikes.Thereasonisthatlowerexogenousriskinvites
financialinstitutionstopayoutmoreindividendsandbonuses,therebyincreasingtheirleverage.This
leadstohighersystemicrisk. Intheend,whatevertheexogenousfundamentalrisk,itisnormalforthe
systemtosporadicallyentervolatileregimes. Lowriskenvironments,liketheGreatModeration,are
conduciveto
greater
buildup
of
systemic
risk.
In
other
words,
alow
volatility
environment,
in
which
financingiseasytoobtain,istheidealfoundationforacreditboom.
Second,financialinnovationcanbeselfdefeating.BruSan(2011)considersasettinginwhichproductive
institutionsareexposedtoidiosyncraticriskinadditiontomacrorisk.Somefirmsgobankruptwhen
theysufferanidiosyncraticshock. Anticipatingpotentialbankruptcyandforeclosurecosts,bond
holderschargeaspreadasacompensationfortheseexpectedlossesupfront. Onemightexpect
financialinnovationthatallowsfirmstohedgeagainsttheseidiosyncraticriskswouldimprovefinancial
stability. However,whenfirmscanhedgetheiridiosyncraticrisktheyfeelemboldenedandtakeon
moreleverage,whichcanmakethewholesystemlessstable.Thus,whilesecuritizationandother
financialinnovations
are
ostensibly
quite
beneficial
in
that
they
decrease
the
costs
of
idiosyncratic
shocksandreduceinterestratespreads,theycanunintentionallyleadtoamplifiedsystemicriskinthe
economy.
3.2BustPhase:LiquidityandDeflationarySpirals
Afterthegradualbuildupofabubbleandtheassociatedimbalances,atriggereventcanleadtothe
burstingofthebubble.ThetriggereventthatcatalyzesthecrisissometimesreferredtoastheMinsky
momentdoesnothavetobeaneventofmajoreconomicsignificancewhenconsidered
independently.Strategiccomplementaritiescanleadtoamplificationoreventomultipleequilibria,with
thepossibilityofajumptoaParetoinferiorequilibrium.Insuchenvironments,evenamodesttrigger
eventcan
cause
large
spillovers
across
the
financial
system.
Spilloverscanbedirectfromoneinstitutiontoitscounterparty,leadingtosocalleddominoeffects,or
theycanbeindirect. Forexample,depositorbankruns,ortheirmodernreincarnationascounterparty
runsinwholesalefundingmarkets,aredirectspillovers.Indirectspillovers,however,ariseeveniftwo
partieshavenocontractuallinks.Theyworkthroughcommonriskexposuresthroughprices,
constraints,andtheendogenousresponsesofmarketparticipants.
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Tobetterillustratetheunderlyingmechanismandtodevelopaframeworkthatallowsustoevaluate
variouspolicymeasures,wesketchheretheBrunSan(2011,2012)model.
Anymodelthatstudiesfinancialinstabilityandtheroleoffinancialfrictionsmustdepartfromthe
representativeagentanalysisandinvolveheterogeneousagents/sectors.Insteadoffocusingspecifically
onthe
sectors
mentioned
in
Section
2,
BruSan
splits
agents
into
three
groups:
productive
agents,
less
productiveagents,andthefinancialsector.Interpretedliterally,entrepreneurscanbethoughtofas
moreproductiveinoperatingapieceofequipment.Viewedmorebroadly,productiveagentsmightalso
bethosewhoderivemoreutilityfromowningahouseorwhosimplyvalueitmorethanothers.They
mightalsomorerisktolerant,lesspatient,youngerorsimplymoreoptimistic.Whatisimportantisthat
someagentswouldliketoscaletheiroperations,i.e.,theircapitalholdings,beyondalevelthattheir
ownfundingwouldallow.
Anotherelementisthatfinancialfrictionslimitfundingandrisksharingamongagents.Forexample,
directfinancialarrangementsarelimitedwhenthefundprovidercannoteffectivelymonitorthe
borrower.SpecificallyinBruSan,contractscanbewrittenonthevalueofphysicalcapitalbutnotonthe
(aggregate)efficiencylevelofcapital.
Thefinancialsectorhasaspecial(monitoring)technologythatpartiallymitigatesthesefinancial
frictions.4 However,toalignincentives,financialfirmsarerequiredtohaveskininthegame.Thatis,
similartothestaticsettingofHolmstrmandTirole(1997),thefinancialsectormustberesponsiblefor
someoftheriskofendborrowers(productiveagents)inordertomitigatefinancialfrictions.Therisk
bearingcapacityofthefinancialsectordependsonhowwellthefinancialsectoriscapitalized
specifically,itdependsonitsnetworth.Ofcourse,iftheproductiveagentshavemorewealth,thenthey
arealsoabletoscaleup.Thestateoftheeconomyisdescribedbythenetworthofthefinancialsector
andthenetworthoftheproductivesector. Aggregatingthenetworthsharesofthefinancialsectorand
endborrowersyieldsavariablethatstronglyaffectseconomicactivity. Whenislow,theeconomy
becomesfinanciallyconstrained. Inspecialcases,becomestheonlystatevariableimportantfor
systemdynamics.
Whenthefinancialsectorissufficientlywealthy,competitiveforceserodeexpectedreturnsforfinancial
firms. Atthatpoint,someofthebankerspayouttheirexcessnetworthandincreaseleveragetoboost
returns. Increasedpayoutsimplyanupperlimitforthewealthshareofthefinancialsector.The
theoreticallowerlimitofthefinancialsectorswealthshareisclosetozero.
Theeconomyissubjecttoexogenousmacroshocksthataffecttheproductivityofphysicalcapital.Either
fewer(or
more)
goods
can
be
produced
with
the
same
amount
of
capital,
as
in
BruSan2011,
or
part
of
thecapitalcanbemisappropriated,asinBruSan2012.Theseshocksaffectthereturnoncapital.Recall
thatthereturnoncapitalislowerforlessproductiveagents,asphysicalcapitalheldintheirhands
produceslessoutput.Inaddition,itmightdepreciatefasterbecausetheymaybelessabletomaintain
thephysicalcapital.
4InBruSan2012,financialintermediariesalsohavetheadvantageinbeingabletoholdadiversifiedportfolio
acrossmanyproductiveagentsprojects.
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Theequilibriumpriceofcapital,q,dependsontheaggregatenetworthshareofthefinancialsectorand
endborrowers,whichmovesbetweentwoextremes0 and*.Theupperpricelimitariseswhenthe
financialsectoriswellcapitalizedand,therefore,capitalispurelyheldbytheproductivesector.When
banksarelesswellfunded,theequilibriumprice,q,dropsasthedemandforcapitalgoodsdeclines.The
lowerpricelimitariseswhenapproacheszeroandallcapitalisheldbythelessproductiveagents.
Anadverseexogenousshockcanleadtosharppricemovementsbecauseofamplifyingadverse
feedbackloops.Wefirstdiscussthreeliquidityspiralsbeforeanalyzingthedeflationaryspiral.Tobetter
understandtheliquidityspiral,itisusefultodistinguishbetweenthreeliquidityconcepts.
1. TechnologicalilliquidityPhysicalcapitalisilliquidifinitialinvestmentisirreversiblethatis,whencapitalcannotbe
convertedbackintoconsumptiongoods. Technically,technologicalilliquidityiscapturedby
adjustmentcostsintheinvestmentfunction. Ofcourse,ifprojectsareshortlived,i.e.capital
depreciatesveryfast,thentheyaredefactoreversible.Thedepreciationratecanbeviewedas
the
duration
of
the
capital
good.
2. MarketilliquidityMarketliquidityishighifcapitalcanbesoldofftootherswithoutalargepriceimpact.
a. Physicalcapitalenjoyshighmarketliquidityifitcanbeeasilyredeployed,becauseitsspecificityislow.Inotherwords,ifithasahighsecondbestuse.
b. Financialclaimshavehighmarketliquidityiftherearenorelatedinformationalproblems:i.e.,incentivesarealignedbetweenprincipalsandagents.
3. FundingilliquidityUnliketechnologicalandmarketliquidity,fundingliquidityreferstotheliabilitysideofthe
balancesheet. Fundingliquidityisprimarilydeterminedbythematuritystructureofdebtand
thesensitivity
of
margins/haircuts.
If
the
margin
can
jump
from
10%
to
40%
overnight,
then
30%ofthemarginloanessentiallyhasthematurityofoneday.
AliquiditymismatcharisesinBruSansinceshortterm(instantaneous)debtfundingisusedtofinance
thepurchasesoflongdurationcapital. Capitalinvestmentdepreciatesonlyatrate(inthehandsof
lessproductiveagents,atrate). Moreover,thetechnologicalliquidityofphysicalcapitalislow
becauseof(dis)investmentadjustmentcosts. Inaddition,marketliquidityislowbecauseofthe
productivitydifferencebetweenmoreandlessproductiveagents.Capitalfiresoldtolessproductive
agentsisemployedonlyatitssecondbestuse.(Notethatliquiditymismatch,notmaturitymismatch,is
important.Forexample,ifmarketliquiditywereperfect,thematuritymismatchwouldnotmatter.)
Liquidityspirals
amplify
any
initial
adverse
productivity
shock.
The
amplification
depends
on
leverage
andfeedbackloopsthatariseaspricesreacttochangesinthenetworthofconstrainedagents.
Interestingly,whenthefinancialsectoriswellcapitalized,financialfirmsreducepayoutsinorderto
avoidassetsales.Thisstabilizesthepriceofcapitalanddampenstheadversefeedbackloop.However,
whenthefinancialsectorislesswellcapitalized,furtheradverseshocksleadtofiresales. Asa
consequence,thepriceofcapitaldropssignificantlyandwithitthenetworthofbanksandend
borrowers.Theseverityofthelossspiraldependsontheinitialleverageofbanksandonthe
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productivitydifferencebetweenmoreandlessproductiveagents.Recallthatlessproductive
householdsprovideaflooronthepriceofcapital,astheycanredeploycapitalinitssecondbestuse.
Thefinancialsectorsleveragedependson1)thepayoutpolicyingoodtimes,and2)assetholdings.
Whenchoosinghowmuchtopayoutintheformofdividendsandbonuses,eachfinancialfirmtrades
offsafety
with
the
cost
of
retaining
earnings.
Holding
extra
funds
inside
the
firm
provides
safety,
especiallyina(endogenously)riskyenvironment,asfirmscansustainnegativeshockswithouttriggering
assetfiresales.
Inbadtimes,firmspayoutislimitedandtheirrisktakingdependsonthefollowingtradeoff. Whenthe
networthofbanksislow,theirprofitopportunitiesarehighascompetitionisrestrained.Themarginal
valueofanextradollarofnetworthishigh.Ontheotherhand,riskishighsincesubsequentnegative
shocksdepresspricesevenfurther.Becauseoftheincreasedmarginalvalueofwealth,alowerchoiceof
leveragewouldhaveledtoasuperioroutcome.Atanymomentintime,institutionsbalancethistrade
offbetweenendogenousreturnandendogenousrisk.Astheirnetworthdrops,theyreducetheir
holdingofcapitalassets.5
Themodelexhibitsinterestingendogenousvolatilitydynamicsduetosystemicrisk.Importantly,
systemicriskdependsonagentsbehavioralresponsesandrisktakingdecisionsbothbeforeandafter
adverseshocks.Themodelalsoexplainstheasymmetry(negativeskewness)ofbusinesscycles.
OnecanextendtheanalysisofBruSan11andintroduceadditionalfundingliquidityrestrictionsthat
explicitlydependonthevolatilityofthepriceprocess(see,e.g.,Phelan(2012)).Aspricevolatility
increases,marginandhaircutrequirementstighten.Inthiscase,anadditionalliquidityspiral,i.e.,the
margin/haircutspiral,emerges(seeBrunnermeierandPedersen(2009)).Highervolatilityleadstohigher
margins,forcinginstitutionstosellmorecapital.Theresultingsharperpricemovements,inturn,
increasevolatility
and
adverse
feedback
obtains.
BruSan2012addsmoneytotheanalysisinordertostudytheinteractionbetweenfinancialstabilityand
pricestability.ThemodelallowsonetostudytheFisherdeflationaryspiralanditsinteractionwiththe
liquidityspirals. Unlikecapital,whichisrisky,moneysroleisasasafestoreofvalue. Outside(fiat)
moneyisissuedbythegovernmentanditsvalueisdeterminedendogenously.Insidemoneyisissuedby
thefinancialsectorintheformofshorttermnominaldebtobligations.
Again,letusstartwiththetwoextremescenarios:1)whenthefinancialsectorisclosetobankruptcy
andhenceessentiallyabsent,and2)whenthefinancialsectorisextremelywellcapitalized.Inthefirst
case,agentscanholdcapitalfortheirownenterpriseandmoney.Productiveagentsarewillingtohold
primarilyphysicalcapital,whilelessproductiveagentstilttheirportfolioprimarilytowardlessrisky
money. Whileallagentsearnthesamereturnfromholdingmoney,productiveagentsearnhigher
returnfromcapital. Inthesecondextremecase,thefinancialsectorhasalargeriskbearingcapacity.
5InBruSan,activeinstitutionsnetworthisalwaysnonnegative.Hence,theydonotgambleforresurrectionas
wasarguablythecaseduringtheS&Lcrisis.IntheongoingGreatRecession,exposurereductionsweremore
prominent.Bankscouldmoreeasilyextractmoneywithdividendandbonuspaymentsthanbygamblingthrough
riskyinvestments.
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Thefinancialsectorfundsitselfthroughshorttermnominaldebt,i.e.,byissuinglargesumsofinside
money,andchannelsthefundstotheproductivesector. Itisassumedthat,unlikeagentswhocan
investonlyintheirownenterprise,thefinancialsectorcandiversifyacrossproductiveagentsprojects.
Asbefore,theextenttowhichlessproductiveagentsarewillingtofundthefinancialsectordependson
banksrisk
bearing
capacity.
The
financial
sector
faces
askin
in
the
game
constraint.
A
well
capitalized
financialsectorcanchannelsufficientfundstotheproductivesector,improvingresourceallocationin
theeconomy.Thisalsoleadstomoredemandforandahigherpriceofphysicalcapital,q.Ontheother
hand,thepriceofmoney,p,isnowlowersincetheextrasupplyofinsidemoneycreatedbythefinancial
sectorcompeteswithoutsidemoneysupply.
Next,consideranadversemacroshock.Asbefore,theliquidityspiralcreatesadverseeffectsonthe
priceofcapitalandintermediariesnetworth.Now,however,thereductioninthefinancialsectorsnet
worthhasasecondimportanteffect.Asthefinancialsectorcutsbackitsexposuretosatisfyitsskinin
thegameconstraint,itissueslessinsidemoneyjustasproductiveagentsareforcedtoselloffphysical
capitaltolessproductiveagents,depressingthepriceofcapital.Themoneymultipliercollapses.Overall
moneysupplyintheeconomyshrinks.6 Hence,thevalueofmoneyincreases,i.e.,deflationarypressure
emerges.
Asdeflationincreasestherealvalueofthefinancialsectorsliabilitiesandtherebyreducesitsnetworth
evenfurther,adeflationaryspiralarises.Becauseofthesetwospirals,anegativeshockhitsthefinancial
sectoronbothsidesofthebalancesheet.Ontheassetside,theliquidityspiraldepressesassetprices
andreducesthebanksnetworth.Ontheliabilityside,therealvalueofliabilitiesactuallyincreasesafter
anegativeshock,leadingtofurthererosionofnetworth.Bothspiralsamplifytheoverallimpactofthe
initialexogenousshock.Notethatholdingmoneyisattractivealsoforhedgingreasons,asintimeof
crisisthevalueofmoneyincreasesasaresultofdeflationaryforces.
Twoimportantinsightsemergefromthisanalysis,whichwillalsoguideourpolicydiscussioninthenext
section:
First,financialintermediariesimposeanegativeexternalityoneachother.Aseachintermediarydelevers,itdoesnotinternalizeitscontributiontoeithertheassetpricecollapseorthe
deflationarypressure.
Second,spiralsafteranadverseshockcauselargeredistributionsawayfromthebankingsector.However,thisredistributiondoesnotbenefitotheragents;rather,itleadstoanoverallwealth
destructionduetoinferiorresourceallocation.
Sofar,anadverseshocksimplyreducesthemoneysupplyasthemoneymultipliercollapses.Inasetting
withnonlogutilityfunctions,moneydemandcanalsoincreaseintimesofcrisisastheprecautionary
savingsmotiveincreases.Atthatpoint,demandforanysafestoreofvaluewouldincreaseevenmore.
6SuchacollapseoccurredduringtheGreatDepression,creatingpainfuldeflationwithlonglastingeffectson
borrowers. However,thisexperiencecontrastswiththatoftherecentfinancialcrisis,wherethemoneymultiplier
collapsewasoffsetbyatremendousincreaseinthemonetarybase.
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Thedemandforotherassetsthoughttobesafewouldriseaswellinthisflighttosafety.Thatis,asset
priceinflationsetsin,whiletheCPIfalls.
Toallowforopenmarketoperations,BruSan2012introducesaperpetualgovernmentbondthatpaysa
fixednominalamountofinterestineveryperiod.Abroadmoneymeasurethenincludesnotonlyshort
termmoney
but
also
this
government
bond.
If
there
is
adanger
that
the
government
might
default
on
longtermbonds,adiabolicloopbetweensovereignandbankingriskarises.Furthermore,themonetary
transmissionmechanismcouldbeimpaired.Section4focusesonpolicyresponsesanddiscussesthese
aspectsinfurtherdetail.
3.3RecoveryPhase
Recoveryfromfinancialrecessionscanbesluggishandprotracted.Sectorswhosefinancesareimpaired
devotetheirresourcestorepairingbalancesheets.AftertheburstingoftheJapaneserealestateand
stockmarketbubble,thenonfinancialbusinesssectorscaledbackinvestmentsandfocusedonpaying
offdebt.Currently,intheUnitedStates,householdsarescalingbackconsumptiontoaccumulate
savings.
In
addition,
the
financial
sector
is
slowly
recapitalizing
itself
through
retained
earnings
to
satisfy
highercapitalrequirements.
BernankeandGertler(1989)wrotethefirsttheoreticalpapertohighlightthepersistenceofbalance
sheetrecessions.Intheirwork,thecorporatesectorreturnstonormalsteadygrowthonlyafteralong
periodofrecapitalization.InBernanke,Gertler,andGilchrist(1999)andKiyotakiandMoore(1997),this
persistenceintothefutureaffectscurrentassetpricesandhencefeedsback,exacerbatingtheinitial
amplificationeffect.BruSan2011givesafullcharacterizationofthevolatilitydynamics.Whilethesystem
isrelativelystablewithreasonablegrowthinthenormalregime,itcanbethrownoffandtrappedfor
sometimeinarecessionwithlowgrowthandlowmarketliquidity.Thishappensaftermovingthrougha
highvolatilityregion.ThestationarydistributioninBruSan2011isUshaped,implyingthatthesystem
spendsmostofitstimearoundthesteadystate, transitionsveryspeedilythroughtheintermediate
regionwithhighvolatility,andalsospendsaconsiderableamountoftimeinthedepressedregimewith
lowgrowth.
Empirically,theprofessionhasnotsettledthequestionofhowfastrecoveryoccursafterfinancial
recessions.ReinhartandRogoff(2009)defineaslumpastheperiodfromthepeakinGDPpercapitato
thedateatwhichthatpeakisregained.Theyprovideempiricalevidenceforasluggishrecoveryphase.
BordoandHaubrich(2012)arguetothecontrary,measuringthespeedoftherecoverybyitsslope.For
theU.S.,onlytheGreatDepressionandGreatRecessionstandoutasslowrecoveries.
Thespeedy
recovery
of
emerging
market
economies
after
asudden
stop
of
capital
inflowcoined
as
thePhoenixMiraclebyCalvo,Izquierdo,andTalvi(2006)alsoseemstocontradicttheabove
mentionedslowrecoveryhypothesisoffinancialrecessions.Acloserlook,however,revealsthatakey
foremergingmarketrecoveryisexportgrowthresultingfromrealexchangeratedepreciation.This
leadstohighergrowthinoutput,workingcapital,andtemporaryemployment.However,despitethe
realexchangeratedepreciation,creditandlongtermemploymentarealsosubduedinemerging
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markets.Overall,theempiricalevidencesuggeststhattheeffecthastointeractwithsomeother
variables,suchashousingdebtorforeignexchange.
4.MonetaryPolicy
Carefullydesignedpolicycanreducethefrequencyoffinancialrecessionsandminimizeinefficiencies
oncetheyhappen.Ouranalysissuggeststhatsomeseeminglynaturalpolicyresponsescanactuallybe
counterproductive.Importantly,contrarytopredominantview,thethreeobjectivesofpricestability,
financialstability,andfiscalgovernmentdebtsustainabilitycannotbetreatedindependentlyfromeach
otherandassignedseparatelytomonetary,regulatory,andfiscalauthorities,respectively.Theyareall
closelyinterlinked.
Thefirstpartofthissectionlooksattheoptimalmonetaryresponsetoanadverseshock,whilethe
secondpartstudiesmonetarypolicyrulesfromanexanteperspectivewithaspecialfocusonmoral
hazard.Section5dealswithfiscalpolicyandrestructuringpolicy.
4.1MonetaryPolicyResponsetoAdverseShocks
Mostcentralbankshavethefollowingmonetarypolicytoolsattheirdisposal:1)shortterminterestrate
policies,2)helicopterdropsofmoney,3)assetpurchaseprograms,and4)collateralpoliciesfor
lendingprograms.(EquityinfusionsandotherrestructuringpoliciesarediscussedinSection5.2.)The
effectivenessofthesetoolsdependsonthecentralbankscredibilityaboutitsfuturebehavior
conditionalonthestateoftheeconomy.
MostmacroeconomicmodelsemphasizetheKeynesianinterestratechannel. Thekeyfrictioninthese
modelsis
some
form
of
price
or
wage
stickiness.
Lowering
the
nominal
interest
rate
leads
to
alower
real
interestrate.Alowerrealinterestratestimulatesaggregatedconsumptionandinvestmentasthe
representativeagentbringsconsumptionforwardandinvestmentprojectsbecomemoreprofitable.In
NewKeynesianmodels,interestratesaresetbyarulee.g.,theTaylorruleandmoneyservesonlyas
aunitofaccount.Thezerolowerboundofthenominalinterestrateisanimportantrestrainingfactor
andthemainjustificationfornonconventionalmonetarypolicyandfiscalmeasures.
TheITheoryofMoneyinBruSan2012stressesanewchannel:theredistributionalchannelofmonetary
policy.Insteadofpricestickiness,financialfrictionsarethesourceofinefficiencies.Monetarypolicy
leadstochangesinvariousassetpricesandthevaluesofdebt/mortgagecontracts.Thismonetary
transmission
channel
works
primarily
through
capital
gains,
as
in
the
asset
price
channel
promoted
by
Tobin(1969)andBrunnerandMeltzer(1972).Lowerinterestratescanalsoincreasetherisktaking
behaviorofinvestorsandassetpricedistortions,asshowninAdrianandShin(2011).
AnimportantelementinBruSan2012isthatassetholdingsarenotsymmetric,andhencemonetary
policyaffectsdifferenteconomicagentsdifferently.Asaconsequence,monetarypolicyredistributes
wealth.Thisredistributiveeffectcanmitigatedistortions,suchasdebtoverhangproblemsthatarise
fromamplificationmechanismsdescribedinSection3. Thesemitigatingeffectscanspurgrowthand
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leadtoanoverallhigherwealthlevelintheeconomy. Forspecificscenarios,monetarypolicycaneven
leadtoParetoimprovements,makingallagentsintheeconomybetteroff.Wethereforerefertothese
effectsasrelativewealthredistributionstostressthatredistributioninoursettingisnotazerosum
game.
Tostudy
monetary
analysis,
we
have
to
add
important
elements
to
the
bare
bones
model
of
BruSan2012describedinSection3.First,acentralbankinBruSan2012paysinterestonreserves
(outsidemoney),whichmirrorstheinstitutionalframeworkintheeurozoneandintheU.S.sincethefall
of2008.Inthemodel,theseinterestpaymentsarefullyfinancedbyseigniorage.Inotherwords,any
interestpolicyisfullyfinancedandbudgetneutralatanypointintime.Varyingtheshortterminterest
rateisthekeyconventionalmonetarypolicytool.
ConventionalMonetaryPolicy
Conventionalmonetarypolicycaninfluencewealthdistributionintwoways.First,loweringtheshort
terminterestratereducesbanksfundingcosts. Ifcompetitionamongbanksislimited,banksarenot
forcedtopassonthecheaperfundingcoststotheircustomersandhenceareabletoincreasetheir
profitmargins. Theincreaseinnetinterestmarginsisaslowwaytorecapitalizebanks.Englishetal.
(2012)showthatbanksinterestincomeistypicallyhigherinalowinterestrateenvironment.
RedistributionaleffectsofmonetarypolicyweredebatedinJapaninthemid1990swhentheBankof
Japanadoptedalowinterestratepolicy.7
Second,interestratepolicycanaffectassetprices. BruSan2012focusesontheredistributionaleffects
causedbyassetpricemovements.Thepaperintroducesalongtermbondspecifically,aconsolbond
withinfinitematuritythatpromisesnominalinterestpayments.Now,interestratepolicyhasanimpact
becauselowshortterminterestratesincreasethevalueoflongtermbondsandredistributewealthto
longtermbondholders.Inthemodel,thecentralbanksimplyreducestheinterestitpaysonoutside
money(reserves)
to
lower
the
short
term
interest
rate.
In
reality,
central
banks
might
also
have
to
conduct(relativelysmall)openmarketoperationsthatexchangeshorttermmoneyforlongtermbonds
toensurethatthenewshorttermratetargetisreached.InBruSan2012,thesectorthatisexposedto
theliquidity/deflationspiralriskholdsthelongtermbond,whenitexpectspolicyresponsestocause
theappreciationofthesebondsindownturns. Hence,anaccommodativeinterestratepolicyafteran
adverseshockpartlyoffsetsthenegativewealthshocks.Thiscanbereferredtoasa"stealth
recapitalization"becauseitisawaytoredistributewealthtowardthedistressedsector.
Notethatthisframeworkemphasizesmoneyasastoreofvalue.Bothshorttermmoneyandlongterm
bondsarestoresofvalueandhencearepartofthetotalbroad(outside)moneysupply.
Forconventionalmonetarypolicytocontrolthelongtermyield,i.e.,toachieveashiftinthelongterm
bondprice,itisnecessarythatthecentralbankcrediblycommittoalowinterestrateuntiltheeconomy
strengthensagain.
7Forexample,Ono(1997)findsnodirectincometransfersfromdepositorstobanks.Banks
surgeinprofitwasprimarilyduetocapitalgainsinlongtermfixedratebonds.
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UnconventionalMonetaryPolicy
Unconventionalmonetarypolicycantakeondifferentforms.First,thefamoushelicopterdropof
shorttermmoneyorlongtermbonds(whichhasafiscalcomponenttoit).Iftheextramoneysupplyis
targetedataspecificsector,thatsectorwillbenefitthemost.Buteveniftheextramoneyisdistributed
symmetricallyamongalleconomicagents,thosethatholdnominalclaimssuffercomparedtoagents
thatown
real
projects,
because
the
overall
price
level
adjusts.
The
relative
redistribution
occurs
betweennominalandrealclaimholders.
Second,assetpurchaseprogramsdirectlybenefittheholdersoftheseassets. Forexample,longterm
bondyieldsaredeterminedbybothcredibleshortterminterestratepolicyandbondpurchase
programs. Forexample,ifabondpurchaseprogrammakesitmoredifficult(easier)tocommittoalow
interestrateenvironment,theoverallimpactofshortterminterestratesonthelongtermyieldmight
bemuted(larger).KrishnamurthyandVissingJorgensen(2011)trytoquantifytheimportanceofvarious
channelsoftheFederalReservesquantitativeeasingprograms.
Thecentralbankcanalsopurchaseother,moreriskyassets.Bydoingso,thecentralbanktakeson
(upsideanddownside)risk.Forexample,thecentralbankcouldpurchaseriskyclaimsorcapitaldirectly,
asinBruSan2012.Iftheassetpurchaseprograminvolvesrealclaims,thenthemoneysupplyincreases.
Thisalsoinducesarelativeredistributionbetweennominalandrealclaimholders.Notethateven
nominalbondswithdefaultriskcanhavearealcomponentifthedefaultprobabilitydependsonthe
pricelevel.
Lendingprogramsarethethirdformofnonconventionalmonetarypolicy.Centralbankshavelenderof
lastresortrole,Bagehot(1877).8Theseprogramsaresubsidizedlendingarrangementswiththepurpose
ofinducingcertaininvestorstopurchaseorholdontoparticularassets.Thisprovidesapricesupportfor
theseassetsanddirectlybenefitsthepreviousholdersoftheseassets.Investorswhotakeadvantageof
thisprogram
benefit
only
to
the
extent
that
they
do
not
compete
the
rents
away.
Unlikewithstraightassetpurchaseprograms,withlendingprogramsthecentralbankassumesonly
downsidetailrisk.Theriskmaterializesonlyifboththevalueoftheunderlyingcollateralfailstocover
theborrowedamountandtheborrowingpartydefaults. Byvaryingthecollateralrequirements,the
centralbankassumesmoreorlesstailrisk.
Whenismonetarypolicymostwelfareenhancing?AsoutlinedinSection3,absentanymonetary
intervention,anadverseshockleadstofiresalesofphysicalcapitalfromproductivetolessproductive
agentsand,inaddition,todeflationarypressure.Monetarypolicythatisaccommodatinginthesestates
of
the
economy
provides
support
for
the
price
of
capital
and
other
assets.
The
analysis
in
BruSan
shows
thatthisismostwelfareenhancingif
1. marketliquidityofcapitalislow,sincethedifferencebetweenproductiveandlessproductiveagentsislarge,and
8Inourframeworkfinancialandpricestabilityarecloselylinkedandweconsiderfinancialstabilityinstrumentsas
partofmonetarypolicyinstruments.
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2. thelevelofexogenousvolatilityislow.Intuitively,iftheproductivitydifferencebetweenagentsislarge,thenreallocatingphysicalcapitaltothe
lessproductiveagentsdestroysmorewealth.Inaddition,thelargerpriceimpactoffiresalesamplifies
theliquidityanddeflationaryspirals.Insuchanenvironment,endogenousriskisveryhigh.When
exogenousrisk
is
low,
the
resources
required
to
effectively
stabilize
the
system
are
low,
and
hence
monetarypolicycanhavethegreatestbenefit.
Theresponsivenessofmonetarypolicydependsonthequantityandmaturityofoutstanding
governmentdebtandotherlongdatedassets,aswellasonwhethermortgageinterestratesare
primarilyfixedorfloating.Forexample,iftheailingsectorholdsmorelongdatedassets,thenasmaller
interestratecutmightsufficetogeneratethesamecapitalgainseffect.Surprisingly,interestrate
derivativesthatinsulatebanksfrominterestrateriskmakemonetarypolicylesseffective.However,
thereisevidencethatlargebankholdingcompaniesusetheseinterestratederivativestoamplify
interestrateriskratherthanreducethisrisk(seeBegenauetal.(2012)).
Linkingthe
ITheory
of
Money
with
the
Fiscal
Theory
of
the
Price
Level:
A
Diabolic
Loop
Sofar,wehaveassumedthatthegovernmentbudgetisalwaysbalancedandhencegovernmentdebtis
sustainable.Indeed,thegovernmentsonlyexpensewastheinterestpaymentsonreservesfinancedby
seignorage.Sincereservesarearelativelysmallpartofthetotalmoneysupply,thisisnotadominant
effect.Next,weenrichtheenvironmenttoallowforthepossibilityofgovernmentdebtbecoming
unsustainablei.e.,aftertheeconomysuffersanadversegrowthshock.ThisallowsustobridgetheI
TheoryofMoneywiththeFiscalTheoryofthePriceLevelandtostudyinflation,capitalflight,andthe
diabolicloopbetweensovereignandbankingrisk.
Whengovernmentdebtbecomesunsustainable,therearethreepossibleregimes.Inthemonetary
dominanceregime,
the
monetary
authority
is
in
the
drivers
seat
in
the
sense
that
adverse
shocks
are
mitigatedbyfiscalspendingcutsinordertoreturntoasustainablefiscalspendingpathandstabilizethe
valueofthecurrency.Inthefiscaldominanceregime,thefiscalauthoritydeterminesgovernment
spending.Indoingso,ithasalargeimpactoninflation,andthemonetaryauthorityisdefactonotinfull
controlofinflation.Proponentsofthisfiscaltheoryofthepricelevelliteraturequestionwhethera
centralbankcaneverbeindependentofthefiscalauthorities.9Thethirdregimeinvolvesadefaulton
governmentdebt.10Ofcourse,exante,therecanbepolicyuncertaintyaboutwhichregimewill
materialize.Thispoliticaluncertaintyaddsanotherlayerofendogenousrisk.
Ifthemarketexpectsthat1)thegovernmentwillnotrestrainitsfiscalspendingand2)thecentralbank
will
not
monetize
the
unsustainable
part
of
future
government
expenditures,
then
long
term
bonds
are
subjecttodefaultandthedifferencebetweensovereignandprivatedebtclaimsvanishes.Inother
words,governmentbondslosetheirmoneynessastheirroleasastoreofvalueiscompromised.The
9FurthercomplicationsariseintheEuropeancontext,inwhichacentralbankhastodealwithseveralfiscal
authorities.See,e.g.,Sims(1999)andCanzonerietal.(2010).10
Governmentsoftendefaultinmoresubtlewaysontheirobligations.Forexample,theymayforcepublicly
ownedpensionfundsandbankstoholdgovernmentpaperatunfavorablerates.Theseandothermeasuresgo
oftenundertheheadingFinancialRepression.
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overallsupplyofsafeassetsdrops.Asimilareffectoccursfordemanddeposits,whendemanddeposit
insuranceisnotsufficientlyfunded.
Animmediateconsequenceofthisuncertaintyisaflighttosafety.Whenthegovernmentbondlosesits
safeharborquality,investorswillshifttootherstoresofvalue,suchasforeigngovernmentbondsor
gold.Which
foreign
government
bonds
are
considered
to
be
safe
depends
on
foreign
countries
debt
sustainabilityandinstitutionalarrangements. Assafeassetsareanequilibriumphenomenon,some
assetscanbeconsideredsafeowingtoselffulfillingexpectations. Ifotherinvestorstendtobuya
certainassetintimesofcrisis,thenthehighervalueofthisassetcanbemoreeasilysustained.Aclassic
exampleisgold,whichhasbeenasafeharborforthousandsofyears.Itsvaluerisesintimesofcrises
eventhoughthefundamentalvalueofgoldisnotstronglytimevarying.
Ifthefinancialsectorholdsalotofgovernmentdebt,thediabolicloopbetweensovereigndebtand
bankingdebtcanexacerbatethesituation.Thereareatleasttwospiralsatworkhere.Astherealvalue
oflongtermbondsdrops,thefinancialsectorcontractsitsbalancesheet.Theresultingcreditcrunch
stiflesrealeconomicgrowth.Lowereconomicgrowthlowersthetaxrevenueforthesovereign,making
adefaultormonetizationofgovernmentdebtmorelikely.Atthesametime,thefinancialsectormight
needtoberecapitalizedbythegovernment.11Theincreasedprobabilityofabailoutmakesitlesslikely
thatthegovernmentwillbeabletohonoritsolddebt. Inaddition,deflationaryandinflationary
pressuresareatwork.
Anegativeshockonsustainabilityofgovernmentdebtcantriggerbothdeflationaryandinflationary
forces.Mechanismsthatleadtodeflationarenotthesameasinflationarymechanisms.Inotherwords,
deflationisnotsimplynegativeinflation.TheFisherdeflationaryforceoutlinedinSection3ariseswhen
acriticalsector,e.g.,thefinancialsector,issuddenlyundercapitalized,possiblybecauseofadropinthe
realvalueofgovernmentbondsheldbybanks.Ifbondpricesdroponfearsofdefaultbythefiscal
authorities,then
deflationary
forces
can
be
very
powerful.
If
the
bond
prices
drop
on
expectations
of
governmentdebtmonetization,theninflationaryforcesareprevalent.Atthesametime,thefinancial
sectorwillcontractifitholdsalargequantityofthisdebt.Thisleadstoanopposingdeflationarypush,
butalsotoadeclineingrowth.Thelattermakesthegovernmentdebtevenlesssustainable,requiring
evenmoremonetizationandinflation.
Inaddition,weshouldalsodistinguishbetweendifferenttypesofinflation.Inflationcanbehelpfulto
overcomedebtoverhangproblemsifitdevaluesdebtandbooststhenominalincomeoftheeconomic
agentsclosetodefault.Ontheotherhand,costpushinflation(e.g.,duetohigheroilprices),ifnot
accompaniedbyhigherwagegrowthofindebtedhouseholds,iscounterproductive.
Furthermore,flightstosafetytootherdomesticassetsleadtoassetpriceinflation.Flighttosafetyto
foreignassetslowerstheexchangerate,makesimportsmoreexpensive,andhenceincreasesCPI
inflation.
11ThisdiabolicloopisveryprevalentintheongoingEuropeancrisis.SeeEuronomics(2011)fortheirESBies
proposalthatalleviatesthisproblem.
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Insummary,duringcrisestimes,theopposinginflationaryanddeflationaryforcesareverypowerful.12
Balancingtheseforcestotargetpricestabilityisespeciallychallenging.Thesystemisnotveryforgiving:
Smallpolicymistakescanleadtheeconomytodriftontoaninflationaryordeflationarypath.In
addition,asmarketparticipantsfinditdifficulttopredictfutureinflation,investmentdeclinesand
growthishindered.Traditionaltransmissionmechanismsareimpairedasinformationaboutpotential
defaultor
monetization
takes
precedence
over
interest
rate
decisions.
4.2MonetaryPolicyRules
Sofar,wehavefocusedonmonetarypolicyresponsesfollowingshocks.Inthissection,wetakeonestep
backandanalyzehowapolicyruleshouldbedesignedfromanexanteperspective.Independentof
whethermonetarypolicytriestomitigatefinancialfrictionsorpricerigidities,anygeneralmonetary
policyrulemusttakeintoaccounthowitaffectseconomicagentsbeliefs.Viewedmoreabstractly,ifa
centralbankcanperfectlycommittoarule,thentheoptimalpolicyruleissimplytheresultofacomplex
implementation/mechanismdesignproblem.Theintentoftheruleistoaffecttheeconomicagents
beliefsandbehaviorinordertosteertheeconomytowardthesociallydesirableobjective.Before
discussinghow
such
rules
affect
economic
agents
behavior,
including
moral
hazard,
we
contrast
the
twodifferentobjectivesmonetarypolicycouldhave:mitigatingdistortionsthatresultfromfinancial
frictionsorfrompricerigidities.
FinancialFrictionView
Inaneconomywithfinancialfrictions,marketsareincomplete.Financialfrictionspreventagentsfrom
insuringeachotheragainstshocks.Hence,shocksleadtoshiftsinthewealthdistribution.Initialshocks
canbeamplifiedthroughpricemovements,andalargepartoftheriskisendogenous.Redistributional
monetarypolicycanmitigatethesewealthshifts.Bydoingso,italsoreducesendogenousriskand
stabilizestheeconomy.Inotherwords,apredictableandwellcommunicatedmonetarypolicyrulecan
provideamissing
social
insurance
contract
across
various
economic
agents.
It
acts
like
acontingent
wealthtaxthattemperswealthshifts.Inthisprocess,itreducesendogenousrisk,enablesmorefunding
tobechanneledtoprofitableprojects,andstimulatesgrowth.
Viewedinamultiperiodsetting,monetarypolicyredistributeswealthalongthewholemultiperiod
eventtree. Atanypointintime,future(contingent)redistributionofwealthcanbeviewedascurrent
redistributionofrisks. Byconductingcertainmonetarypolicymeasures,thecentralbankassumestail
risk.Forexample,whenlendingtofinancialinstitutionsagainstcollateral,thecentralbankassumesrisk
inthestateoftheworldinwhichthecounterpartygoesbankruptandthecollateralvaluefallsshortof
theborrowedamount.Strictlyspeaking,thecentralbankisnotassumingthetailriskbutsimply
redistributingittoothersprimarilytothosewhoholdnominalclaims.Again,indoingso,theoverall
riskmaybereduced.Hence,thisisredistributiononlyinarelativesense.Inanabsolutesense,itis
possiblethatthewellbeingofalleconomicagentswillbeimproved.
12SeealsoLeijonhufvud(2012).
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Ofcourse,anyformofinsuranceleadstomoralhazard,asagentschangetheirexpectationsand
behavior.Someofthechangesaredesirablebecausetheyreduceendogenousrisk.Othersareexcessive
andhavetobeaddressedwithmacroprudentialregulation.
PriceStickinessView:AContrast
Beforewe
deal
with
the
moral
hazard
question,
it
is
worth
contrasting
the
financial
friction
view
with
astylizedNewKeynesianperspective.Thereareatleastthreemajordifferences.
First,thekeyfrictionispricestickiness,notfinancialfrictions.Tosharpenthecontrast,letusfocuson
NewKeynesianmodelsinwhichmarketsarecomplete,andhencearepresentativeagentanalysisis
justified.Themainroleofmonetarypolicyinthesemodelsistoovercomedistortionsthatarisefrom
thepricerigidity.Monetaryrulestrytoinfluencethebehaviorofpricesetters,whichinturninfluence
thereactionofothereconomicagentsandtheresponseofoutputtorealshocks.Asbefore,adheringto
policyrulesisimportanttoensurethateconomicagentscanformreliableexpectationsandtheir
reactionmaximizesthedesiredobjective.
Second,the
New
Keynesian
paradigm
focuses
on
the
role
of
money
as
aunit
of
account.
As
a
consequence,interestraterules,liketheTaylorRule,fullycharacterizemonetarypolicy,andmoney
onlyplaysaroleinthebackground(seeKing(2002),Woodford(2003)).Incontrast,theItheoryandthe
workbyKiyotakiandMoore(2008)focusonmoneyasastoreofvalue.Thelatternaturallyintegrates
unconventionalpolicymeasuresandmacroprudentialtoolsinthemonetaryanalysis.
Third,NewKeynesianmodelswithcompletemarketsfocusonasingleinterestrateanditsdeviation
fromthenaturalrate.Financialfrictionsnecessitateariskcomponentandnotsimplyanintertemporal
perspective.
Wenowreturntothefinancialfrictionviewofmonetarypolicyanddiscussthepotentialofpolicyrules
increatingmoralhazard.
MoralHazard:InteractionwithMacroprudentialRegulation
Likeanyinsurancescheme,expostredistributionalmonetarypolicycomesatagreatprice:moral
hazard.Economicagentsmightrespondtoanticipatedconditionalredistributioninunintendedways.
Forexample,financialintermediariesmighttakeontoomuchrisksincetheyanticipatethatanyadverse
shockwillthenbemetwithsomeaccommodativemonetarypolicythat(implicitly)recapitalizesthem.
Thismakesthesystemexantemoreriskyandunderminestheoverallobjective.
Hence,exante,thecentralbankwantstocommititselftolimittheredistributiveaspectsofmonetary
policy.Ex
post,
it
would
like
to
redistribute
wealth
to
stimulate
the
economy,
but
this
undermines
the
credibilityoftherule.Thecentralbankfacesaclassictimeinconsistencyproblem.Undercertain
circumstances,themoralhazardproblemmaybesoseverethatthecentralbankiscorneredand
forcedtoabandonitsrulebookaltogether.Whenthishappens,thecentralbanklosescredibility,andits
abilitytosteertheeconomyisimpaired.
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Thecentralbankcanbecorneredby1)fiscalauthoritiesand2)systemicallyimportanteconomic
agents.Fiscalauthoritieswilltrytoforcethecentralbanktomonetizegovernmentdebtinorderto
avoidpoliticallyunpopularausteritymeasures.Brinksmanshipbetweenproponentsofmonetary
dominanceandproponentsoffiscaldominanceleadstouncertaintyintheeconomy. Theaimofany
centralbankshouldbetomonitorthefiscalsituationinordertoavoidbattlesbetweenfiscaland
monetaryauthorities.
Toavoidbeingcorneredbysystemicallyimportanteconomicagents,suchaslargefinancialinstitutions,
centralbankshavetwotypesoftoolsattheirdisposal:1)acleverdesignofexpostrecapitalizationrules
thatreducemoralhazardproblems,and2)exantemeasuresthatleanagainstthebuildupofsystemic
risk.
Forexample,anexpostrecapitalizationschemethat