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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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

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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

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-0.8

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0 5 10 150

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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

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A: interest rate spread (Annual Basis Points)

0 5 10 15

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C: investment

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B: credit

0 5 10 15

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E: net worth

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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.

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Price of Capital, Q

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Probability of a bank run in t+1, p

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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.