Leverage, Finance and Macroeconomics

google EPI chatelain theorie financiere Jean-Bernard Chatelain

Macroeconomics
Macroeconomics: started after the 1929 Crisis. Keynes and others. National Accounts, macro-economics aggregates 2 separate fields in the 1990s. - Business Cycles: Pro-market, Competitive Real Business Cycles, small costs of cycles for representative agent. Y=AKaL1-a - Growth: Pro-public intervention, Externalities in Growth models (Paul Romer (1983)). Y=AKL1-a

The current crisis and macroeconomics

They say they want a revolution

DSGE models bashing. Harsh debates (Krugman, Buiter,). Institute for New Economic Thinking (Soros).

August 2009

The havoc wrought by our recent global financial crisis has vividly demonstrated the deficiencies in our outdated current economic theories, and shown the need for new economic thinking right now. We already are a global community, ranging from Nobel prize, who have emerged out from the shadows of prevailing economic thought, attracted by the promise of a free and open economic discourse. [Georges Soros funding, INET, 2010]

Macroeconomics in Crisis?
Cover of the Economist, August 2009. Institute for New Economic Thinking 2010 (videos) financed by Georges Soros. Failure of the dominant views pre-2007. Saltwater versus Freshwater 1976 (David Warsh: Knowledge and the wealth of nations 2006): Krugman versus Lucas, MIT Harvard versus Chicago

Highly controversial
In 2009, Paul Krugman (Princeton), Brad DeLong (Berkeley) and Willem Buiter (LSE) argued against Robert Lucas (Chicago) that they are also unable to provide adequate monetary and fiscal policy answers to the crisis.

Why do they?
Guilt by economists misunderstanding of the upcoming crisis? Old memories. Fighting back against Lucas rational expectations? A new macroeconomic regime with weakly regulated financial sector?

Interaction Growth/Cycle
Possibility to disentangle growth component from cycle component from macroeconomic times series. Cycles: say 6-8 years. Recurrent financial crisis and depression comes back. But large Crisis lasts long and affect the growth trend, not only the cyclical component: USA 1929-1946, Japan 1990s-2010.

Plan: 3 parts
1. We have a problem 2. Solutions of yesterday 3. Solutions for tomorrow

I. We have a problem

YES,

IT
CAN!

IT: World map showing Real GDP Growth Rate for 2009

I. Why

it will happen again tomorrow.

We need a reason to do a revolution in mainstream macroeconomics. The reason is: It will happen again in the next 3 business cycles (3x8years). It : another large world major financial crisis in developped countries.

One world crisis every 80 years? Or every three cycles?

The low frequency of the last two major world crisis (1 every 80 years) is related to the stability period which followed Bretton Woods (1945-1973). This period is also related to a great reversal in the balance of power for promoting international private banking and international capital flows, with respect to the period 1870-1940.

A great reversal: From A

Regime A: Weakly regulated international finance regime. 1. Large size of capital flows 2. Opacity of capital flows (offshore finance). 3. Unreliable asset prices 4. Unreliable balance sheet of banks, unreliable estimates of bankruptcy risk 5. Risk taking behaviour due to the bailout of too interconnected banks.

 to B
Regime B: Strongly regulated international finance. 1. Control of international capital flows. 2. Control of the amount of credit upwards or downwards by large retail banks in order to limit bubbles at the national level (strong macroprudential policy, credit control). 3. Strong involvement of government or of the public sector in the allocation of credit or capital.

Strengthes/Weaknesses
Regime A: + Better allocation of world capital. - High probability of world (core OECD countries, NOT the periphery) systemic bankruptcy with large cost. Regime B: - Weaker allocation of world capital. + Very low probability of world systemic bankruptcy (including low contagion effects).

Condition for A to B in 1945

Weak bargaining power of international banking. 1.Decrease in trade 2.Decrease in capital flows (war). 3.Banking Regulations in 1933

Condition for A to B in 1945

4. War economies and expected reconstruction economies with strong involvement of government in the banking sector and in the allocation of capital. 5. Willingness to move to fixed exchange rate and international stability for the western world. Others

Conditions from A to B in 2011

Strong bargaining power of international finance. None of the former sixth conditions met. Banking sector regulations: 1933 (4 years) : Glass Steagall Act. 2011 (3 years): Basel 3 in the next 8 years. International Coordination issues among Jurisdictions; Dissents inside Nations.

Many factors why governments may not fight opacity

International capital flows and opacity creating bubbles. One short term strategy of exit of the crisis. Creating bubbles in emerging economies. Banks profitability restored quickly. Government cash given to banks comes back Probability of sovereign default decreases.

Benefits of Opacity during crisis management (2)

Nobody buy losses with probability one originated by a crisis. Opacity allows to spread those losses in larger portfolios to investors (return tickets to Jersey for bad banks ).

Benefits of Opacity during crisis management (3)

Opacity on losses allows soft budget constraints on financial markets with hard immediate budget constraints. It allows an optimal timing of annoucement of losses. It allows gamble for resurrection. Hence, some regulators may write about regulation after the crisis

Low frequency of world crisis: a Bretton Woods II

To reach a low frequency of world crisis, one needs a Bretton Woods II along with a great reversal of the balance of power of international private banking, limiting its activities. The (geo)-political conditions for a great reversal where built in by 1945. They are very far from being built in 2011. There will not be a Bretton Woods II in the next years. The probability of world systemic bankruptcy and related crisis will remain high.

1 decade over 3 ?
A depression: a lost decade. 1/8 decade Less 3 decades of Bretton Woods 1/5 decade 1880-1929: higher frequency: 1/3 cycle

Not foreseen?
Prior: it is rare (80 years?). Low probability The cost is small (cf. Sweden 1990s knows better than Argentina 1990s). Small costs of cycles.

II. Solutions of Yesterday

Financial accelerator DSGE

Imperfect capital markets with bankruptcy costs for non financial firms and also for banks. Debt backed by collateral valued at next period asset price. Next period asset price determined as the fundamental value of the asset (efficient market hypothesis).

Hypothesis: collateral backed aggregate credit rationing

(t+1: +1 year or +10 years average?)

(1 + rt ) B t < mZ t E t qt 1 K t E t qt 1  qt Bt < mZ t 1   rt . qt K t qt

Alternative Hypothesis: Default risk premium

Bt rt ! r0  h E t qt 1 qt K t q t

Wealth accumulation: Persistence

qt K t  K t 1 ! Bt  Bt 1  FK t    rt 1 Bt 1 1

Asset pricing: Arbitrage

(t+1: +1 year or +10 years average?)

rt ! qt !

G'  t ,lenders  E t qt 1  qt K qt G'  t ,lenders K rt

E t qt 1 !   rt qt  G'  t ,lenders 1 K

Jackson Hole consensus 1999-2001

Central Banks should not try to stop asset price bubbles before they burst. They have to accommodate ex post, to decrease their repo interest rate only once the bubble burst. Taylor rules with asset prices have a negligible effect in DGSE including the financial accelerator effect.

We explore the implications of asset price volatility for the management of monetary policy. We show that it is desirable for central banks to focus on underlying inflationary pressures. Asset prices become relevant only to the extent they may signal potential inflationary or deflationary forces. Rules that directly target asset prices appear to have undesirable side effects. We base our conclusions on (i) simulation of different policy rules in a small scale macro model and (ii) a comparative analysis of recent U.S. and Japanese monetary policy (Bernanke Gertler, NBER WP, 2000, (abstract, p. 2)).

Game of Seven Errors

1. Understated cost in terms of GDP loss: Higher Persistence, Slower Recovery.

Not (half life) 30-50% GDP recovery the year following the shock (cf damped exponential dynamics).

Typical (DSGE) macro-dynamics

DSGE answers
1) Assume SEVERAL exogenous UNCORRELATED (miss causal links) LARGER negative shocks each year since 2007. 2) Assume LARGER PERSISTENCE (autocorrelation coefficient) of shocks since 2007.

 Credit Cycle Redux (Cordoba, Ripoll, IER, 2004)

Theoretical studies have shown that under unorthodox assumptions on preference and production technologies, collateral constraints can act as a powerful amplification and propagation mechanism of exogenous shocks. We investigate whether or not this result holds under more standard assumptions. We find that collateral constraints generate a typically small output amplification. Large amplification is a knife-edge type of result.

Business Cycle Redux The utility loss due to consumption volatility is far too small, even with the financial accelerator

It indicates that economic instability at the level we have experience since the second world war is a minor problem, even relative to historically experiences inflation and certainly relative to the cost of modestly reduced rates of economic growth. Lucas (1987, p.30)

Constrained and unconstrained Euler consumption growth equation

(First order condition of intertemporal optimisation). Always taken for granted for up to 200/400 pages of macroeconomic textbooks. Smooth consumption volatility 1) Empirical failure. 2) Lagrange multipliers with different resources constraints such as credit constraints (including the expected valuation of asset prices) implies different equations.

rt  V g (C ) ! W

Discrete time

C (t  1) 1  r (t ) ! 1 V C (t )

1 W

Seven errors
2. Effect of the fall of asset prices on subsequent GDP loss understated. 3. Variation of asset prices with respect to output variation and with respect to the variation of the consumer price index understated. 4. Little additional information of asset prices with respect to CPI and output gap: asset prices are predicted not to be useful in Taylor rules.

Seven errors
5. The ability of a monetary policy with a Taylor rule to accommodate the crisis is overstated. 6. The ability of the fiscal policy to accommodate the crisis is understated due to an emphasis of the ricardian effect. 7. The asymmetry of the volatility of asset prices for a negative shock with respect to a positive shock was not predicted.

To sum up
The COST of the crisis is much larger than expected from the past (compare to Sweden 1990s << Argentina). The models understated the effect on the economy: the Taylor rule type sharp reaction of the central bank was not sufficient to counter the effect of a fall of the housing price on U.S. GDP. Liquidity problems and systemic stability of the financial systems outside the model (Taylor rule reaction only). Fire Sales.

III. Solutions for tomorrow

Conceptual Instructions: New assumptions

New assumptions have to match the structural research program which followed the Lucas critique: Model explicitly agents and governments preferences, their expectations and the interactions between government and agents preferences and expectations. More flexible that several hypothesis added in rational expectations business cycles theory (likely to face creative destruction)

Two easy pieces

1. No systemic default/bankruptcy or liquidity uncertainty trap second equilibrium 2. Efficient market hypothesis: assets value = 10 years expected average value. 2b) No Ponzi Game condition. 2c) Unique stable path dynamics

The Return of Depression Macroeconomic THEORY Fisher (1933) Keynes (1936)

1. Systemic default equilibrium.

Haberler (1941) TRUNCATED Irving Fishers Depression Macroeconomics Theory (1933): But clearly, over-investment rather than over-indebtedness is the primary cause of the breakdown We may thus conclude that the debt-factor plays an independent role as intensifier of the depression, but can hardly be regarded as an independent cause of the breakdown.

Fishers (1933) Depression Macroeconomics: The Capsizing regime

To take another simile, such a disaster is somewhat like the capsizing of a ship which, under ordinary conditions, is always near stable equilibrium, but which, after being tipped beyond a certain angle, has no longer this tendency to return to equilibrium, but, instead, a tendency to depart from it.

versus the Stability Corridor

But if the over-indebtedness is not sufficiently great to make liquidation thus defeat itself, it is then more analogous to stable equilibrium; the more the boat rocks, the more it will tend to right himself.

The Capsizing Regime versus the Stability Corridor

Systemic default/bankruptcy Equilibrium = Liquidity Uncertainty Trap

Systemic crisis equilibrium: high proba of default due to lack of confidence, depositors runs or interbank lending collapse, then banking crisis, then government bailing out, then public debt crisis, then taxes, savers and/or wage earners pay: transfer from old to young, with large swings in income distribution (lenders/borrowers).

 Liquidity Uncertainty Trap Expectation driven equilibrium

Consistent with the structural research program Modelling expectations of government bailing out or not and of depositors or bankers lending to distressed financial institutions. A Persistent Liquidity UNCERTAINTY Trap and/or a liquidity trap .

Distincts Policy Objectives

1. Stability Corridor: 2% inflation, 2% growth, mild distributional issues. 2. Liquidity Trap: avoid Deflation and zero bound on nominal interest rate. spender of last resort 3. Liquidity Uncertainty Trap: restore Confidence and Liquidity on the interbank, and/or the deposit and/or the sovereign debt markets. lender of last resort

Distinct Macro Policies Tools in the Liquidity Uncertainty Trap 1. Unconventional monetary policy matters. 2. Unconventional budgetary policy matters: Lender of last resort for banks + output recovery - solvency of sovereign debt 3. Huge Uncertain distributional conflicts between savers, financial intermediaries, wage earners, current working
generation/future working generation (+15 years), public/private sector, lenders/borrowers, IMF, Germany/other countries; INSURANCE

Credibility Dilemma
Credibility for Inflation Targeting Credible LIMITED Money Creation. Independance from government. Credibility to restore confidence for Financial Stability Credible UNLIMITED Money Creation for banks and for buying government bonds. No independance from government

( Radical Uncertainty ?)
Radical Uncertainty: First time event; or Proba set to zero or 1:10.000 for an event with 1:100. Uncertainty is mostly distributional: about whos going to pay for the losses and when? Private Investors? Banks? Governments? Wage earners? Next generation? ECB? IMF? Germany? Greece? Iceland?

1b. Incentive Compatibility without Ex Post Fraud

A variant of excluding ex post systemic risk. Default is taken into account ex ante with incentive compatibility constraints: Return when cheats = Returns when honest. Then: AGENTS NEVER FRAUD. Taken as microeconomic foundation, design, implementation,... Used a lot in microeconomic corporate finance .

1b. Incentive Compatibility (2)

Pbm 1: Those models suggest that the EX ANTE rational regulation of international capital markets is always able to eradicate FRAUD completely (Judge Jean De Maillard (2004)). Alternative: Crime and Ex-Post Probability of Punishment models (Becker (1968)). P<1/10.000 for international financial fraud transaction (except for extremely large fraud: Kerviel, Madoff).

1b. Incentive Compatibility (3)

Pbm 2: No EX POST default and management of default due to fraud, no need of Government or IMF ex post lender of last resort. The current causal chain may be missing: Solvency of banks + Lender of last resort: THEN default risk transferred to government sovereign debt THEN budgetary policy dilemma.

2. Reject The Efficient Markets Hypothesis

valuation of assets = expected 10 years average fundamental value Else: No bubbles. No over-valuation. No liquidity crisis, leading to too few exchanges on the financial markets, with improper price. No fire sales and asymmetry of reactions to negative shocks versus positive shocks.

Efficient market hypothesis and Lucas critique

One may model according to the structural research program Two groups of agents have different sets of (possibly asymmetric) information and expectations, Then an asset price may differ from its fundamental value .

2B. Reject the unique stable path dynamics for asset prices
The linearization around the equilibrium of the unique stable path leading to a unique long term equilibrium, reducing the study of macroeconomics dynamics to qualitatively similar responses of macroeconomic variables to shocks. Here, the fundamental value is on the stable saddle path, leading to the very long run perpetual rent value.

Stable path
Intertemporal optimization with discount rate leads nearly always to saddlepath dynamics. Only one path of lower dimension is stable. Additional assumption: Very Long Run Rational expectations : rule out ALL unstable paths by assumption, although they are a RESULT of the equations of the model. But the volatility of ASSET PRICES/CAPITAL on this path is the LOWEST with respect to all the other (unstable) paths (business cycles REDUX).

Business Cycle / Market Timing Rational Behaviour

Once stock market cycle discrepancies accepted, even with unknown causal microfoundations: investors adapt: Arbitrage between short run returns (+1 year) for bull or bear markets makes money for RATIONAL lenders-investors. Differs from doing arbitrage between average returns over 10 years ( fundamental arbitrage ). Cf. Shleifer: Unstable Banking .

Consequences
1. Underestimates the volatility of asset prices 2. Alters their relationship with macroeconomic real aggregates. 3. Eliminates the non-linearity of the optimizing model 4. Rules out adaptive market timing (sudden stops) behaviour. 5. Rules out a second low equilibrium with liquidity uncertainty trap

2C. Reject the No Ponzi Game condition

Add on for doing interesting macro Not necessary for optimization. Utility<Infinity. Rule out bubbles from the model. Inconsistent with growth miracles. Necessary for Ricardian equivalence . No effect of budgetary policy. 5. Infinite horizon solvency different from short run solvency (collateral constraints). 1. 2. 3. 4.

g ( B) r

Short run (1 year) [cycle timing], medium run (10 years) versus infinite horizon solvency

(1 + rt ) B t 1 1 X t 1 Yt   g t 1 Y - G t   g t 1 G versus : NoPonziGame : E t g t 1 Y ! E t g t 1 B rt

The average realized real rate of return on government debt for major OECD countries over the last 30 years has been smaller than the growth rate. Does this imply that governments can play a Ponzi debt game, rolling over their debt without ever increasing taxes? O.J. Blanchard and P. Weil: Dynamic Efficiency, the Riskless Rate, and Debt Ponzi Games under Uncertainty (NBER 1992 The Berkeley Electronic Journals in Macroeconomics,
Advances in Macroeconomics: 2001).

GDP, net public debt, real 10 years govt bonds yields: 544 OECD annual observations.

Low real rate Intermediate of interest. real rate of interest 60% 16% Debt/GDP decreases G(B)<G(Y) 45% Debt/GDP increases G(B)>G(Y) 55% r<G(B)<G(Y) 12/544=2% G(B)<r<G(Y) 131/544=24%

Textbook theory No Ponzi Game Condition 24% G(B)<G(Y)<r 102/544=19%

r<G(Y)<G(B) 74/544=14%

G(Y)<r<G(B) 198/544=36%.

G(Y)<G(B)<r 27/544=5%

Conclusion: What comes next?

Related literature
1. 2. 3. 4. 5. Asian Crisis, international economics. Post internet bubble literature Japanese Crisis 1990s-2000s. Macro prudential regulation Microeconomics of banking and liquidity crisis. 6. Overlapping Generation Models

1. Asian Crisis
A lot has been written on Asian Financial Crisis, following Krugman and others. Lots of focus on twin crisis (exchange rate and banks crisis), including debt in foreign currency (US Dollar) in emerging economies.

2. Post Internet Bubble literature.

The post internet bubble literature. The Bank of International Settlements (BIS, in Basel) reports (Borio and Lowe) on twin shocks of equity prices and housing prices. Housing prices fall are worse the equity prices fall in the US. Simultaneous fall are indeed worse.

3.The Japanese Crisis 1990s-2000s

Single Country liquidity trap. Revival for the global liquidity trap threat. Inefficient Fiscal Policy? Long lasting banking crisis. Lasting Zombie lending to bankrupt banks and firms.

4. Macro-prudential regulation (Bank of Int. Settlements).

Limit financial structure thresholds: aggregate loan to value. Penality for banks and shadow banks when not complying. Not openly said: Old style control of credit. The virtue of state control of credit in the allocation of capital and limiting systemic risk. HOT TOPIC TODAY.

5. Microeconomics of banking: Liquidity, Bank runs, Systemic Risk

Ongoing literature on the microeconomic regulation of banks and shadow banks, Basel III, limiting risk taking (DIAMOND DYBVIG (1983) paper). Internation banking supervision and lender of last resort. Opacity of international banking, not openly said capital control (cf. post Bretton Woods) and offshore finance. Liquidity crisis, fire sales and asset prices.

6. Overlapping Generations Models (Pensions)

More freedom of thought , (Matsuyama) No Ricardian Equivalence Multiple equilibria Transfer of the cost of crisis to the next generation, pensions, pensions funds. Empirical connexion less direct (Kotlikoff) Unfortunately: 10% of contents in graduate macroeconomic textbooks with respect to infinite horizon agents models.

Ongoing Crisis and Macroeconomics Literature

1. 2. 3. 4. 5. 6. Leverage for banks and for firms Interbank liquidity Asymmetric reaction to shocks Large shock Assets fire sales Systemic crisis

Coming into macroeconomics

Work in progress
Morris and Shin (Banks) Brunnermeier Kiyotaki, Gertler Goodhart Tsomocos

In the making
1. Not as radically different from DSGE than advertised by some authors. Similar outcomes although much larger swings, with larger impulse shocks hence larger propagation. 2. Still very orthodox with respect to efficient asset pricing and efficient market hypothesis. 3. Sometimes unelegant modelling with many heavy equations 4. Need for an undergraduate level model.

Krugmans (2002) fourth generation crisis sketch

3 examples paving the way 1

Marcus Miller and Joseph Stiglitz (2010): Leverage and Asset Bubbles: Averting Armageddon with Chapter 11? Economic Journal Two equilibria including one with systemic risk, Unstable Path for Asset Prices.

2
Paul De Grauwe (2010): Behavioral Macroeconomics (Book online).

Asset prices fluctuations outside fundamental value, two regimes shifts

3
Anil Kashyap, Richard Berner, Charles Goodhart, (Tsomocos) (2011). The Macroprudential Toolkit, IMF Economic Review 59(2).

Asymmetry of downward shocks due fire sales, and consequences for stabilization policies.

Broadening the view

Political Economy: Distribution conflicts, Competing Jurisdictions

Microeconomics of Financial Regulation

Financial Macroeconomics: Monetary, MacroPrudential (Credit) and Budgetary Policies

Lengthy adjustment delay?

Key assumptions in the current way of doing mainstream macroeconomics may not be changed for a long time, Because some researchers benefits from rents using their favourite technology learned technique (DSGE), and need time to adjust for creative destruction.

Changing ones mind from 1929 to 1933

MORE DETAILS (additional slides)

1. Standard Macroeconomics 2. Financial Macroeconomics

Standard macroeconomics
Causality from Real variables to Financial variables. Perfect capital markets. Financial structure does not matter (debt/net worth). Complete capital markets. Efficient Capital Market Hypothesis.

Lucas Critique
The Lucas critique (1976) suggests that if we want to predict the effect of a policy experiment, we should model the "deep parameters" (relating to preferences, technology and resource constraints) that govern individual behavior. We can then predict what individuals will do, taking into account the change in policy, and then aggregate the individual decisions to calculate the macroeconomic effects of the policy change.

Dynamic stochastic general equilibrium modeling (abbreviated DSGE ) The DSGE methodology attempts to explain aggregate economic phenomena, such as economic growth, business cycles, and the effects of monetary and fiscal policy, on the basis of macroeconomic models derived from microeconomic principles (INTERTEMPORAL UTILITY OPTIMISATION)

DSGE: Favourite Models of Central Banks 2003 onwards

Since DSGE models are constructed on the basis of assumptions about agents' preferences, it is possible to ask whether the policies considered are Pareto optimal, or how well they satisfy some other social welfare criterion derived from preferences

First DSGE = RBC

Real business cycle (RBC) theory builds on the neoclassical RAMSEY growth model, under the assumption of FLEXIBLE prices, to study how real shocks to the economy might cause business cycle fluctuations. The paper of Kydland and Prescott (1982) is often considered the starting point of RBC theory and of DSGE modeling in general.

DSGE
New-Keynesian DSGE models build on a structure similar to RBC models, but instead assume that prices are set by monopolistically competitive firms, and cannot be instantaneously and costlessly adjusted; Sticky Prices and Wages; Money plays a Role in the short run. Central Banks behaviour is, for example, a Taylor rule. (Rotemberg and Woodford (1997), Woodford (2003) book. The European Central Bank (ECB) has developed a DSGE model, often called the Smets-Wouters (2003) model, which it uses to analyze the economy of the Eurozone as a whole

Smets-Wouters (2003)
The equations in the Smets-Wouters model describe the choices of three types of decision makers: households, who choose how much to work, to consume, and to invest; firms, which choose how much labor and capital to employ; and the central bank, which controls monetary policy.

Smets Wouters
The model approximately describes the dynamics of GDP, consumption, investment, prices, wages, employment, and interest rates in the Eurozone economy. In order to accurately reproduce the sluggish behavior of some of these variables, the model incorporates several types of frictions that slow down adjustment to shocks, including sticky prices and wages, and adjustment costs in investment.

Bob Solow - Chari

The United States Congress hosted hearings on macroeconomic modeling methods on July 20, 2010, to investigate why macroeconomists failed to foresee the Financial crisis of 2007-2010. Note: DSGE are not forecasting models.

Chari
The models have all kinds of heterogeneity in behavior and decisions... people's objectives differ, they differ by age, by information, by the history of their past experiences. Not all heterogeneity are sensible? DGSE expected to be so flexible that it will be a theory of everything? (cf String Theory?).

Solow: too close to Representative Agent self-regulated optimal reactions to shocks

The point I am making is that the DSGE model has nothing useful to say about anti-recession policy because it has built into its essentially implausible assumptions the conclusion that there is nothing for macroeconomic policy to do. I think we have just seen how untrue this is for an economy attached to a highly-leveraged, weakly-regulated financial system. But I think it was just as visibly false in earlier recessions (and in episodes of inflationary overheating) that followed quite different patterns

II. Financial Macroeconomics

Reverse Causality from Financial Variables to Real variables.

Financial Macroeconomics
Financial Macroeconomics intends to take into account the effect of Asset Prices (housing prices, equity prices, bonds prices, exchange rates) and of the Financial Structure of non financial Firms, of Banks and other financial intermediaries (leverage or debt/assets ratio, liquidity ratios) and of Households (debt/net worth ratio) on Macroeconomic Fluctuations AND Growth of Aggregates real variables such as the Gross Domestic Product.

Economic Thought
Because economies regularly faced financial crisis (including the 1929 crisis), Financial Macroeconomics has a long history since the 19th century. Clment Juglar, Knut Wicksell, Irving Fisher, John Maynard Keynes, Charles Kindleberger, John K. Galbraith, Hyman Minsky and Ben Bernanke, the current chairman of the FED.

Imperfect capital markets

QUANTITY or QUANTITATIVE CONSTRAINT: Credit rationing, which depends on financial structure. PRICE or COST of capital: depends also on financial constraint.

The cost of credit increases with B(t)/Ep(t+1)H(t)

One has: r=r0+f(B(t)/Ep(t+1)H(t)) The larger the CURRENT leverage (B(t)/p(t)H(t)), the larger the probability of default, the larger the RISK PREMIUM for bonds and credit. The higher the EXPECTED GROWTH of asset PRICES, the lower the RISK PREMIUM on bonds and credit. With a strong expected decline of asset prices, the cost of of credit increases.

Example: Firms
r Capital Demand(t-1) Credit Supply (t-1) New share issues (t-1)

Equity(t-1) i k Ret. earnings Debt New share issues

Constant Returns to Scale: Credit Rationing and increase of net worth (cash flow)
r Kiyotaki and Moore's Credit Cycle with Credit Rationing Capital Demand (t)=(t-1) E1 CashFlow(t) i Equity(-1) E2

k k 1 Ret. earnings Debt k 2 New share issues

Constant Return to Scale: Credit Curve rising with leverage

case where demand(t-1)=t
r

Bernanke, Gertler and Gilchrist Broad Credit Channel Dynamics

E1 CashFlow(t) i Equity(-1)

E2

Capital Demand (t)=(t-1)

k Ret. earnings k 1 Debt k 2

Efficient market hypothesis

The 2 other ideas are compatible with the Efficient Market Hypothesis: P(t)=Expected discounted sum of cash flows of the asset, taking into account all the information.

Efficient Market Hypothesis?

Allocation of international capital: surfing from the Asian Bubble to the Internet Bubble to the Housing Bubble to the next bubble (on China and India stock market?). What if prices are very rarely close to their fundamental value? World demand recovery hopes are relying on opaque lending of Chinese firms. Are asset prices in China correctly valued? Are Chinese statistics reliable?