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FinancialFrictionsinMacroeconomics
LawrenceJ.Christiano
NorthwesternUniversity
BalanceSheet,FinancialSystem
Assets Liabilities
BankDebt
BankEquity
Bankloans
Securities,etc.
BalanceSheet,FinancialSystem
Assets Liabilities
BankDebt
BankEquity
Bankloans
Securities,etc.
Frictionsbetween
financialinstitutionsand
theirlenders.
Sourceoffinancialcrisis,
bankruns,rollovercrises,
etc.
Macroprudentialpolicy
BalanceSheet,FinancialSystem
Assets Liabilities
BankDebt
BankEquity
Bankloans
Securities,etc.
Financialfrictions
betweenbankersand
borrowers.
Perhapstheprimary
frictionin‘normaltimes’,when
macroprudentialisundercontrol.
Outline
• Financialfrictionsfor‘normaltimes’• Assetsideofbankbalancesheets.
• Providesanaturalinterpretationofbusinesscycleswhen:• Weadoptaparticularmodeloffinancialfrictions(BGG)
• Incorporateaparticularshock(Riskshock).
• Financialfrictionsfor‘crisistimes’• Liabilitysideofbankbalancesheets.
• Theanalysisofmacroprudential policyquestions:• Whatleveragerestrictionsshouldbeplacedonbanks?
• Howshouldthoserestrictionsbevariedoverthebusinesscycle?
• Shouldyoubeeasyintoughtimesandtoughineasytimes?
• Sometoughpracticalissues.
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
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1
2
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Cyclical Behavior of Interest Rate Spread
detrended BAA minus 10-year TreasuryHP filtered GDP
Interestratespread
strongly
countercyclical!
Counter-cyclicalityofInterestRateSpread• Consistentwiththeideathatriseinriskinesshassomethingtodowithrecessions.
• Let’sseewherethisideatakesus…
• Bernanke-Gertler-Gilchrist(1999)proposeofwayofthinkingaboutaneconomyinwhichtheinterestratespreadreflectstheriskinessofindividualentrepreneurs(idiosyncraticrisk).
• Ofcourse,interestratespreadsreflectotherfactorstoo,likeliquiditypremia….
• AdoptatwistontheBGGModel:• theriskinessofentrepreneurscanvaryovertime.
• Putthiswholemechanisminafullyspecified,mediumsizedDSGEmodel,asinChristiano-Motto-Rostagno(AER2014)
• EstimateeverythingusingBayesianmethods.
EconomicImpactofRiskShock
0.5 1 1.5 2 2.5 3 3.5 4
0.1
0.2
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0.5
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0.8
0.9
1
idiosyncratic shock
dens
ity
lognormal distribution: 20 percent jump in standard deviation
ss *1.2
Lendersscaredoflending
becauseoflargenumber
ofentrepreneursexpected
inlefttail.
Entrepreneurspayhigherspreadover
riskfreerate,andborrowless.
Entrepreneursinvestless;GDPfalls;
consumptionfallsbecauseofjob
losses;stockmarketfalls;inflation
falls:RECESSION!
Istheredirectevidenceofgreatercross-sectionalriskinrecessions?
• Yes
• Cross-sectionalstandarddeviationofrateofreturnonequity.
• Non-financialfirmsinCenterForResearchinSecuritiesPrices(CRSP)database.
• Thosedatadoshowevidenceofcounter-cyclicality.
Cross-sectionalstandarddeviationiscountercyclical
HowMuchofUSBusinessCyclesCanweExplainwithRiskAlone?
• Asurprisinglylargeamount.
• Estimationdelivers:
• Estimatesoftheriskshock.
• Weask:
• WhatwouldthedatahavelookedlikeifONLYtheriskshockhadbeenactive?
RoleoftheRiskShockinMacroandFinancialVariables
WhyDoestheEconometricsliketheRiskShockSoMuch?
• Inpart:
• riskshockprovidesastraightforwardinterpretationofthecountercyclicalinterestratespread.
• Anotherreason:
• Theimpulseresponsefunctiontoacontractionaryriskshocklooksalotlikearecession.
0 5 10 15
-0.5
-0.4
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0F: consumption
0 5 10 15
-1
-0.8
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-0.4
-0.2D: output
0 5 10 150
0.02
0.04
0.06
0.08
0.1I: risk, st
response to unanticipated risk shock, x0,0
response to anticipated risk shock, x8,0
0 5 10 150
10
20
30
40
50
A: interest rate spread (Annual Basis Points)
0 5 10 15
-3.5-3
-2.5-2
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C: investment
0 5 10 15-4
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B: credit
0 5 10 15
-5-4-3-2-10
E: net worth
0 5 10 15-0.4
-0.3
-0.2
-0.1
0
G: inflation (APR)
Figure 3: Dynamic Responses to Unanticipated and Anticipated Components of Risk Shock
Lookslikeabusinesscycle
What’sthemodelgoodfor?
• Canthinkabouthowmonetarypolicyshouldrespondtoanincreaseininterestratespreads(shouldcutrates).
• CanbeusedtounderstandwhyincludingcreditgrowthandthestockmarketinaTaylorrulemightbeagoodidea(see,Christiano,etal,JacksonHolepaper,2010).
• Openeconomyversioncanbeusedtothinkaboutfinancialdimensionofexchangeratedepreciation(seeMihaiCopaciuandCristianBulete,CentralBankofRomania).
• Depreciationmakesdomesticgoodscheaperandstimulatesoutput.
• Depreciationimposescapitallossesonunhedgedborrowersinforeigncurrency,causingthemtocutbackspendingandreducingoutput.
Financialfrictionsonliabilitysideofbankbalancesheets
• ThisislocationofthefinancialproblemsintheUSfinancialcrisis.
• Macroprudentialpolicyisaboutpreventingthoseproblemsfromhappeningagain.
• But,musthaveaclearideaofwhatthoseproblemswere!
• BeginwithalittlebackgroundontheoriginsofthecrisisandGreatRecession.
Background
• AllstoriesaboutthethefinancialcrisisandGreatRecessionbeginwiththehousingboom.
• BoomwasfueledbyafloodofmoneypouringintotheUSviatheUScurrentaccountdeficit.
Americanshavebeenabsorbingmoregoodsthantheyproduceformanyyears.
CurrentAccountDeficit
• GDP(Y)accountingidentity:
• Tradesurplus(deficit,ifnegative)is:
• Negativecurrentaccountis(approximately)X– M<0.
• So,currentaccountdeficitisasituationwhenAmericansabsorbmoregoods(C+I+G) thantheyproduce,Y.
• Whatcomponentofconsumptionwastheculprit?
Y=C+I+G+X- M
Y- C- I- G=X- M
ThefallinthecurrentaccountisfullyaccountedforbyariseinC
TwoHypothesesAboutCauseofCapitalInflows
• Hypothesis#1:Americanswentonaconsumptionbinge.
• Weexpecttoseerealinterestratesrise.
• Hypothesis#2:ForeignersdevelopedanappetiteforUSfinancialassets(Bernanke’s‘SavingsGlutHypothesis’)
• Narrativefor#2:• foreignbuyingofUSfinancialassetsleadstoappreciationofdollar(hence,tradedeficit).
• Thisisthe‘overvalueddollar’,theChinese‘currencymanipulation’everyonecomplainedsomuchabout.
• GeneralbuyingofUSassetsleadstoastockmarketboom,makingAmericansfeelricher,soconsumptionrises.
• Weexpecttoseerealinterestratesfall.
Hypothesis#2Wins
WhydidSoMuchMoneyGoIntoHousing?
• AlthoughUScurrentaccountdeficitwithEuropenearlybalanced,grossflowsarehuge.
• MoneyflowedtoEuropeandthenflowedbackagain.
• EuropeaninstitutionsineffectpartofUSbankingsystem.
• HyunShincallsthisthe‘BankingGlut’, (Shin,HyunSong.2012.“GlobalBankingGlutandLoanRiskPremium.”IMFEconomicReview,60(2),155–192)
From:Justiniano,Primiceri,Tambalotti,‘CreditSupplyandtheHousingBoom’
IncreaseSupplyofFundstoHousingDroveDown
Mortgagerates(ConsistentwithHypothesis#2.)
Source:Justiniano,Primiceri andTambalotti (2015),“TheEffectsoftheSavingandBankingGlutontheUSEconomy”.
ConsistentwithideathathousingpurchasesbeingfundedbyInflowofforeigncapitalcorrespondingtocurrentaccountdeficit.
Houseprices
Currentaccount
Ok,SoThat’stheBackground
• Whathappenednext?
Trigger:housepricesstoppedrisinginMay2006
Wouldnothavefallensomuchif
therehadnotbeenabankrun.
Whatturnedthehousingpricecorrectionintoadisaster?
• Initialviewbymanypeople:
BigShortView• Lowlendingstandardsmadeeconomyahouseofcards.
• Whenthesystemcameunderpressure,itcrumbled:• defaults&foreclosures
• housepricedrops
• moredefaults&foreclosures
• collapseindemandduetonegativewealtheffect(zerolowerboundkickedin).
• GreatRecession.
• Viewhasbeenchallengedinseveraldetailedstudiesofmortgages(Albanesi,DeGiorgiandNosal,2016,‘CreditGrowthandtheFinancialCrisis:ANewNarrative’)
• Creditgrowthduringboomanddefaultsduringthecrisisconcentratedatmid/topofcreditscoredistributionforalldebtcategories.
EmergingConventionalView:BankRun
• GaryGorton:• MisunderstandingFinancialCrises:WhyWeDon'tSeeThemComing,OxfordUniversityPress
• SlappedbytheInvisibleHand:ThePanicof2007,OxfordUniversityPress,2010.
• BenBernanke:TestimonybeforeCongressional‘FinancialInquiryCommission’,WashingtonD.C.,September2,2010.
• Nobodysawitcomingbecauseitwasarunonabankingsystemwedidn’tknowwassobigandsovulnerabletoruns.
Whydiditlastsolong?
• Ascredittohousingsectordriedup(withcollapseofshadowbankingsystem),housingpricesfellsharply.
• Fallinhousingpricesmadehomeownersfeelpoor,andcutbackspending.
• Firmsseeingfewersales,cutbackinvestment.
• Economyinatailspin.
• Fedcouldn’tsaveitbyusualcutinR becauseR hitlowerbound.
• Perfectstorm:
• Bankrunoccurred,whenrateswerealreadylow.
• Fedoutofammunition.
Thisiswhatabankrunlookedlikeinthe19th century:Diamond-Dybvig run.
Bankrunsin2007and2008weredifferentanddidnotlooklikethisatall(Gorton)!
Itwasarollovercrisisinashadow(invisibletonormalpeople)bankingsystem.
Rollovercrisis• Considerthefollowingbank:
• Thisbankis‘solvent’:atcurrentmarketpricescouldpayoffallliabilities.
• Supposethatthebank’sassetsarelongtermmortgagebackedsecuritiesandtheliabilitiesareshortterm(sixmonth)commercialpaper.
• Thebankreliesonbeingabletorolloveritsliabilitieseveryperiod.• Normally,thisisnotaproblem.
Assets Liabilities120 Deposits: 100
Banker net worth 20
Rollovercrisis
• Nowsupposethebankcannotrolloveritsliabilities.
• Inthiscase,thebankwouldhavetosellitsassets.
• Ifonlyonebankhadtodothis:noproblem,sincethebankissolvent.
• But,supposeallbanksfacearolloverproblem.
• Nowtheremaybeabig problem!
• Inthiscase,assetsmustbesoldtoanotherpartofthefinancialsystem,apartthatmayhavenoexperiencewiththeassets(mortgagebackedsecurities).
TheDramaofaRollOverCrisisBroughttoLifeinSomeGreatMovies!
Rollovercrisis
• Arollovercrisis:whenallbanksinanindustry(e.g.,mortgagebackedsecuritiesindustry)areunabletorollovertheirliabilities.
• Theonlybuyersofthesecuritieshavenoexperiencewiththem,sotheywon’tbuywithoutapricecut(firesale).
• Interestingly,thebuyersofthesecuritieswillallcomplainathowcomplex theyareandhownon-transparent theyare.
• But,therealproblemisthatbuyersinafiresalearesimplyinexperienced.
• TherollovercrisishypothesiscontrastswiththeBigShorthypothesis:assetswerefundamentallybad (Mian andSufi).
Rollovercrisis
• Whenthewholeindustryhastosell,thenbankbalancesheetscouldsuddenlylooklikethis:
• Multipleequilibrium:balancesheetcouldbetheabove,withrun,orthefollowing,withnorun:
• Aruncouldhappen,ornot.
• Thisisexactlythesortoffinancialfragilitythatregulatorswanttoavoid!
• Underrollovercrisishypothesis,thiswasthesituationinsummer2007.
Assets Liabilities90 Deposits: 100
Banker net worth -10
Assets Liabilities120 Deposits: 100
Banker net worth 20
Firesalevalueofassets:
RolloverCrisis:RoleofHousingMarket
• Whatmattersistheactualvalueofassetsandtheirfiresale value.
• Ifbankissolventunder(firesale value),thenprobabilityofruniszero.
• RolloverCrisisHypothesis:• pre-2005,nocrisispossible,
• post-2005crisispossible.
Pre-housing market correction Post-housing market correction
Assets Liabilities120 (105) Deposits: 100
Banker net worth 20 (5)
Assets Liabilities110 (95) Deposits: 100
Banker net worth 10 (-5)
Howtothinkaboutregulationwhentheriskisofarollovercrisis.
• Onepossibility:modeltherollovercrisisdirectly.
• Bestmodelofrollovercrisisatthistime:Gertler-Kiyotaki (AER2015).
• TheyadapttherollovercrisismodelofsovereigndebtcreatedbyCole-Kehoe(JIE1996).
• Cole-KehoerelatedtoDiamond-Dybvig.
Run,
s=1
s=2
s=3
s=4
…
Steady
state
s=T+2≈∞
Possible states: s=1, 2, 3,…, T+2.Bank run, s=1. Nobank runins>1.Ineachno-runstate there isachance
ofaruninthe next state, unless
s=2.
Runstate
s=1.
100 200 300 400
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0.91
Price of Capital, Q
100 200 300 4000
0.01
0.02
0.03
0.04
Probability of a bank run in t+1, p
100 200 300 4000
0.01
0.02
0.03
0.04
Bank net worth, N
OneHundredYearStochasticSimulation
100 200 300 400perc
ent d
evia
tion
from
ste
ady
stat
e
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PolicyUseofModel
• Investigatetheimpactonfinancialstabilityofleveragerestrictions.
• Thisanalysisishard!
• Notclearhowyouintroducelotsofshocks,actualinvestment,openeconomy,currencymismatch,etc.
• Atadeeperlevel,computingequilibriumrequiresknowingwhathappensinthecrisisstate.
• Seemsunlikelyotherthanforpedagogicpurposes.
• Alternative:assumethatgovernmentswillalwaysactaslenderoflastresort.
• Constructmodelsthatdonotallowrollovercrisis,butdocapturemoralhazardimplicationsofbailouts.
Conclusion
• I’vereviewedmodelsoffinancialfrictionsthatappearedinterestingbeforeandaftercrisis.
• Modelsoffrictionsontheassetsideoffinancialfirmsseemlikelytoalwaysbeimportantandinteresting.
• Discussedmodelingtheliabilitysideoffinancialfirmbalancesheets.• Difficulttradeoffs.
• Modelthingscorrectly,butthat’sperhapsintractable.
• Takefullgovernmentbailoutasexogenous(sonorolloverrisk),anddomacroprudentialpolicytomanagetheresultingmoralhazardproblems.
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