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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012

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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2

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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5

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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6

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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8

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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9

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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10

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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11

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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12

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


13/37


13

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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14

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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15

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


16/37


16

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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17

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.


18/37


18

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


19/37


19

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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20

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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21

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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22

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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23

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.


24/37


24

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.


25/37


25

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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26

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.


27/37


27

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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28

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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29

Thecentralbankcanbecorneredby1)fiscalauthoritiesand2)systemicallyimportanteconomic

agents.Fiscalauthoritieswilltrytoforcethecentralbanktomonetizegovernmentdebtinorderto

avoidpoliticallyunpopularausteritymeasures.Brinksmanshipbetweenproponentsofmonetary

dominanceandproponentsoffiscaldominanceleadstouncertaintyintheeconomy. Theaimofany

centralbankshouldbetomonitorthefiscalsituationinordertoavoidbattlesbetweenfiscaland

monetaryauthorities.

Toavoidbeingcorneredbysystemicallyimportanteconomicagents,suchaslargefinancialinstitutions,

centralbankshavetwotypesoftoolsattheirdisposal:1)acleverdesignofexpostrecapitalizationrules

thatreducemoralhazardproblems,and2)exantemeasuresthatleanagainstthebuildupofsystemic

risk.

Forexample,anexpostrecapitalizationschemethat

kansas city fed paper

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