Financial Crises, Pecuniary Externalities, and Financial Regulation

Paper Session

Saturday, Jan. 7, 2017 10:15 AM – 12:15 PM

Swissotel Chicago, Zurich B
Hosted By: American Economic Association
  • Chair: Arvind Krishnamurthy, Stanford University

Moral Hazard Misconceptions: The Greenspan Put and Other Examples

Gideon Bornstein
,
Northwestern University
Guido Lorenzoni
,
Northwestern University

Abstract

Policy discussions on financial market regulation tend to assume that whenever a corrective policy can be used ex post to ameliorate the effects of a financial crisis, this policy always entails negative side effects in terms of moral hazard ex ante. This paper shows that this is not a general theoretical prediction and that ex ante and ex post policies can be either substitutes or complements depending on the environment. The paper focuses on a few examples. The first example looks at the case of ex post monetary policy. We show that if the central bank does not intervene by monetary easing following a large drop in asset prices, this creates an aggregate demand externality that makes borrowing ex ante inefficient. If instead the central bank follows an optimal discretionary monetary policy and intervenes, the aggregate demand externality disappears reducing the need for ex ante intervention.

Multiple Equilibria in Open Economy Models With Collateral Constraints: Overborrowing Revisited

Stephanie Schmitt-Grohe
,
Columbia University
Martin Uribe
,
Columbia University

Abstract

Open economy models with collateral constraints display nonconvexities for plausible parameter configurations. These nonconvexities can give rise to multiple equilibria. Existing quantitative studies have avoided this problem by choosing parameter configurations for which nonconvexities disappear. This paper establishes analytically the existence of multiple equilibria in infinite-horizon open-economy models in which tradable and nontradable output serves as collateral. In this environment, the economy displays self-fulfilling financial crises in which pessimistic views about the value of collateral induces agents to deleverage. The paper shows that under plausible calibrations, there exist equilibria with underborrowing. This result stands in contrast to the overborrowing result stressed in the related literature. Underborrowing emerges in the present context because in economies that are prone to self-fulfilling financial crises, individual agents engage in excessive precautionary savings as a way to self insure. The underborrowing equilibrium displays less frequent financial crises than is optimal.

A New Dilemma: Capital Controls and Monetary Policy in Sudden Stop Economies

Michael B. Devereux
,
University of British Columbia
Eric Young
,
University of Virginia
Changhua Yu
,
Peking University

Abstract

The dangers of high capital flow volatility and sudden stops have led economists to promote the use of capital controls as an addition to monetary policy in emerging market economies. This paper studies the
benefits of capital controls and monetary policy in an open economy with financial frictions, nominal
rigidities, and sudden stops. Specifically, international borrowing must be in foreign currency and
collateralized by units of domestic capital whose value fluctuates over time; when the collateral
constraint binds there is an inefficient financial accelerator effect that leads to sharp declines in output and employment along with a large decline in asset prices and a sharp depreciation of the real exchange rate. We have three main results. First, during a crisis optimal monetary policy deviates from price stability in order to stimulate the economy; this effect is small unless both nominal wages and prices are rigid. Second, the effects of commitment depend critically on the nature of the collateral constraint ‐‐ if collateral is valued at its current price, commitment gains are negligible and capital controls are welfare‐improving, whereas if collateral is valued at its expected price tomorrow commitment gains are significantly larger and capital controls reduce welfare but are used in a time‐consistent equilibrium anyway. Third, under the expected value constraint there is no scope for macro‐prudential interventions ‐ neither nominal interest rates nor capital inflow taxes are changed unless the economy is currently in a crisis, independent of whether there is a potential crisis in the future.

Fire-Sale Externalities

Eduardo Davila
,
New York University
Anton Korinek
,
Johns Hopkins University and NBER

Abstract

This paper characterizes the efficiency properties of competitive economies with financial constraints and fire sales. We show that two distinct pecuniary externalities occur in such settings: distributive externalities that arise from incomplete insurance markets and can take any sign; and collateral externalities that arise from price-dependent financial constraints and are conducive to over-borrowing. For each type of externality, we identify three sufficient statistics that determine optimal taxes on financing and investment decisions to implement constrained efficient allocations. We illustrate how to employ our framework in a number of applications, which highlight how small changes in parameters may cause the sufficient statistics that drive distributive externalities to flip sign, leading to either under- or over-borrowing. We also show that financial amplification is neither necessary nor sufficient to generate inefficient fire-sale externalities.
Discussant(s)
Eduardo Davila
,
New York University
Sebastian Di Tella
,
Stanford University
Andres Drenik
,
Columbia University
Arvind Krishnamurthy
,
Stanford University
JEL Classifications
  • E3 - Prices, Business Fluctuations, and Cycles
  • F3 - International Finance