Multiple Equilibria and Financial Crises

May 14 and 15, 2015
Roger Farmer of University of California, Los Angeles and Jess Benhabib of New York University, Organizers

Ricardo Lagos, New York University and NBER, and Shengxing Zhang, London School of Economics

Monetary Exchange in Over-the-Counter Markets: A Theory of Speculative Bubbles, the Fed Model, and Self-Fulfilling Liquidity Crises

Lagos and Zhang develop a model of monetary exchange in over-the-counter markets to study the effects of monetary policy on asset prices and standard measures of financial liquidity, such as bid-ask spreads, trade volume, and the incentives of dealers to supply immediacy, both by participating in the market-making activity and by holding asset inventories on their own account. The theory predicts that asset prices carry a speculative premium that reflects the asset's marketability and depends on monetary policy as well as the microstructure of the market where it is traded. These liquidity considerations imply a positive correlation between the real yield on stocks and the nominal yield on Treasury bonds — an empirical observation long regarded anomalous. The theory also exhibits rational expectations equilibria with recurring belief driven events that resemble liquidity crises, i.e., times of sharp persistent declines in asset prices, trade volume, and dealer participation in market-making activity, accompanied by large increases in spreads and abnormally long trading delays.

Romain Ranciere, International Monetary Fund, and Aaron Tornell, University of California, Los Angeles

Financial Liberalization, Debt Mismatch, Allocative Efficiency and Growth

Financial liberalization increases growth, but leads to more crises and costly bailouts. Ranciere and Tornell present a two-sector model in which liberalization, by allowing debt-denomination mismatch, relaxes borrowing limits in the financially constrained sector, but endogenously generates crisis risk. When regulation restricts external financing to standard debt, liberalization preserves financial discipline and may increase allocative-efficiency, growth and consumption possibilities. By contrast, under unfettered liberalization that also allows uncollateralized option-like liabilities, discipline breaks down, and efficiency falls. The model yields a testable gains-from-liberalization condition, which holds in emerging markets. It also helps rationalize the contrasting experience of emerging markets and the recent U.S. housing-crisis.

Assaf Patir, Hebrew University

Synchronization and Bias in a Simple Macroeconomic Model

This note illustrates how agents' beliefs about economic outcomes can dynamically synchronize and de-synchronize to produce business-cycle-like fluctuations in a simple macroeconomic model. Patir considers a simple macroeconomic model with multiple equilibria. The equilibria correspond to different ways that agents can use a sunspot variable to forecast future output, which are self-fulfilling. Agents are assumed to learn to use the sunspot variable through econometric learning. The researcher shows that if different agents measure output with a slight bias (though the average bias in the economy vanishes), this leads to a complex nonlinear dynamic of synchronization of beliefs about the equilibrium being played. The economy fluctuates between long eras where the agents' beliefs are almost homogenous and therefore they are coordinated on the use of the sunspot, and eras of dispersed beliefs where the coordination mechanism fails. Patir shows that the equation describing the evolution of the economy is similar to the Kuramoto model, a prototypical model of synchronization phenomena, and makes some first attempts at mapping the connections.

Edouard Schaal, New York University and Mathieu Taschereau-Dumouchel, Wharton School of the University of Pennsylvania

Coordinating Business Cycles

Schaal and Taschereau-Dumouchel develop a quantitative theory of business cycles with coordination failures. Because of a standard aggregate demand externality, firms want to coordinate production. The presence of a non-convex capacity decision generates multiple equilibria under complete information. The researchers use a global game approach to show that, under incomplete information, the multiplicity of equilibria disappears to give rise to a unique equilibrium with two stable steady states. The economy exhibits coordination traps: after a negative shock of sufficient size or duration, coordination on the good steady state is harder to achieve, leading to quasi-permanent recessions. In the authors' calibration, the coordination channel improves on the neoclassical growth model in terms of business cycle asymmetries and skewness. The model also accounts for features of the 2007-09 recession and its aftermath. Government spending is harmful in general as the coordination problem magnifies the crowding out. It can, however, increase welfare — without nominal rigidities — when the economy is about to transition to the bad steady state. Simple subsidies implement the efficient allocation.

Russell Cooper, Pennsylvania State University and NBER, and Kalin Nikolov, European Central Bank

Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty

This paper studies the interaction of government debt and financial markets. Both markets are fragile: excessively responsive to fundamentals and prone to strategic uncertainty. This interaction, termed a diabolic loop, is driven by government willingness to bail out banks and the resulting incentives for banks not to self-insure through equity buffers. Cooper and Nikolov provide conditions such that the diabolic loop is a Nash Equilibrium of the interaction between banks and the government arising from instability in debt markets.

Dmitry Plotnikov, International Monetary Fund

Hysteresis in Unemployment and Jobless Recoveries

In this paper, Plotnikov develops and estimates a general equilibrium rational expectations model with search and multiple equilibria where aggregate shocks have a permanent effect on the unemployment rate. If agents' wealth decreases, the unemployment rate increases for a potentially indefinite period. This makes unemployment rate dynamics path dependent as in Blanchard and Summers (1987). Plotnikov argues that this feature explains the persistence of the unemployment rate in the U.S. after the Great Recession and over the entire postwar period.

Mikhail Golosov, Princeton University and NBER, and Guido Menzio, University of Pennsylvania and NBER

Agency Business Cycles

A novel theory of labor market fluctuations is advanced. Golosov and Menzio analyze how firms need to fire non-performing workers with some positive probability in order to provide them with an ex-ante incentive to exert effort. In order to provide this incentive at the lowest cost, firms load the firing probability on the states of the world where the worker's cost of losing a job relative to the firm's cost of losing a worker is highest. When there are aggregate decreasing returns to scale to the value of unemployment, the states of the world where the worker's cost of losing a job is highest in relative terms are the states of the world with the highest unemployment. Hence, an individual firm finds it optimal to fire its non-performing workers in exactly the same states where other firms fire their non-performing workers workers. The strategic complementarity between the resolution to the agency problem faced by different firms leads to endogenous, stochastic fluctuations in unemployment, job-destruction and job-finding rates. The magnitude and the morphology of these fluctuations closely remembers those observed in the U.S. economy.

Roger Farmer

Global Sunspots and Asset Prices in a Monetary Economy (NBER Working Paper No. 20831)

This paper constructs a simple model in which asset price fluctuations are caused by sunspots. Most existing sunspot models use local linear approximations: instead, Farmer constructs global sunspot equilibria. His agents are expected utility maximizers with logarithmic utility functions, there are no fundamental shocks and markets are sequentially complete. Despite the simplicity of these assumptions, Farmer is able to go a considerable way towards explaining features of asset pricing data that have presented an obstacle to previous models that adopted similar assumptions. The model generates volatile persistent swings in asset prices, a substantial term premium for long bonds and bursts of conditional volatility in rates of return.

Gianluca Benigno, London School of Economics, and Luca Fornaro, CREI, Universitat Pompeu Fabra and Barcelona GSE

Stagnation Traps

Guillaume Rocheteau, University of California, Irvine; and Randall Wright, University of Wisconsin, Madison and NBER; and Sylvia Xiaolin Xiao, University of Melbourne

Open Market Operations

Standard monetary theory is extended to incorporate liquid government bonds in addition to currency. This allows us to study different monetary policies, including OMO's (open market operations). Rocheteau, Wright, and Xiao consider various specifications for market structure, and for the liquidity of money and bonds -- i.e., their acceptability or pledgeability as media of exchange or collateral. Theory delivers sharp predictions, even when there are multiple equilibria, and can generate novel phenomena like negative nominal interest rates, endogenous market segmentation, liquidity traps and the appearance of sluggish nominal prices. Importantly, authors show how to explain differences in asset acceptability or pledgeability using information frictions.

Feng Dong, Shanghai Jiao Tong University; Pengfei Wang, Hong Kong University of Science and Technology; and Yi Wen, Federal Reserve Bank of St. Louis

Credit Search and Credit Cycles

Guido Lorenzoni, Northwestern University and NBER, and Ivan Werning, MIT and NBER

Slow Moving Debt Crises (NBER Working Paper No. 19228)

Lorenzoni and Werning study slow moving debt crises, self-fulfilling equilibria where high interest rates due to fears of higher future default leads to a gradual but faster accumulation of debt, ultimately validating investors' fears. The researchers show that slow moving crises arise in a variety of settings, both when fiscal policy follows a given rule or when it is chosen by an optimizing government. The authors discuss how multiplicity is avoided for low debt levels, for sufficiently responsive fiscal policy rules, and for long enough debt maturities. When the equilibrium is unique, debt dynamics are characterized by a tipping point, below which debt falls and stabilizes and above which debt and default rates grow. The researchers provide game-theoretic foundations for their approach.