International Finance and Macroeconomics Pricing
October 25, 2013
Luis Catão and Gian Maria Milesi Ferretti, International Monetary Fund
Catão and Milesi-Ferretti examine the determinants of external crises, focusing on the role of foreign liabilities and their composition. Using a variety of statistical tools and comprehensive data spanning 1970 to 2011, the authors find that the ratio of net foreign liabilities to GDP is a significant crisis predictor. This is primarily because of the net position in debt instruments; the effect of net equity liabilities is weaker and net foreign direct investment (FDI) liabilities seem if anything an offset factor. The authors also find that: 1) breaking down net external debt into its gross asset and liability counterparts does not add significant explanatory power to crisis prediction; 2) the current account is a powerful predictor, either measured unconditionally or as deviations from conventionally estimated "norms"; 3) foreign exchange reserves reduce the likelihood of crisis more than other foreign asset holdings; and 4) a parsimonious probit containing those and a handful of other variables has good predictive performance in- and out-of-sample. The latter result stems largely from the authors' focus on external crises sensu stricto.
Javier Bianchi, University of Wisconsin and NBER
Bianchi develops a non-linear DSGE model to access the interaction between ex-post interventions in credit markets and the build-up of risk ex ante. During a systematic crisis, bailouts relax balance sheet constraints and mitigate the severity of the recession. Ex ante, the anticipation of such bailouts leads to an increase in risk-taking, making the economy more vulnerable to a financial crisis. The optimal policy requires, in general, a mix of ex-post intervention and ex-ante prudential policy. The author also analyzes the effects of bailouts on financial stability and welfare in the absence of ex-ante prudential policy. His results show that the moral hazard effects of bailouts are significantly mitigated by making bailouts contingent on the occurrence of a systematic financial crisis.
Philippe Bacchetta, University of Lausanne, and Eric van Wincoop, University of Virginia and NBER
While the 2008–2009 financial crisis originated in the United States, there were steep declines in output, consumption and investment of similar magnitudes around the globe. This raises two questions. First, given the observed strong home bias in goods and financial markets, what can account for the remarkable global business cycle synchronicity during this period? Second, what can explain the difference relative to previous recessions, when there was far weaker co-movement? To address these questions, Bacchetta and van Wincoop develop a two-country model that allows for self-fulfilling business cycle panics. They show that a business cycle panic will necessarily be synchronized across countries as long as there is a minimum level of economic integration. Moreover, they show that several factors generated particular vulnerability to such a global panic in 2008: tight credit, the zero lower bound, unresponsive fiscal policy and increased economic integration.
Kristin Forbes, MIT and NBER; Marcel Fratzscher, DIW Berlin and Humboldt University Berlin; and Roland Straub, European Central Bank
Assessing the effectiveness of capital controls and macroprudential measures is complicated by selection bias and endogeneity; countries that change their capital flow management (CFM) policies often share certain characteristics and are responding to changes in variables (such as capital flows and exchange rates) that the CFMs are intended to influence. Forbes, Fratzscher, and Straub address these challenges by using a propensity-score matching methodology. They also create a new database with detailed information on weekly changes in controls on capital inflows, capital outflows and macroprudential measures from 2009 to 2011. The results indicate that certain types of CFMs, especially macroprudential measures, can significantly reduce some measures of financial fragility such as bank leverage, inflation expectations, bank credit growth, and exposure to portfolio liabilities. However, most CFMs do not significantly affect other key targets such as exchange rates, capital flows, interest rate differentials, inflation, equity indices, and different volatilities. The main exception is that removing controls on capital outflows may reduce real exchange rate appreciation. Therefore, certain CFMs can be effective in accomplishing specific goals, especially macroprudential measures aimed at reducing specific financial vulnerabilities, but many other popular measures may not be able to accomplish their stated aims.
Varadarajan Chari, University of Minnesota and NBER; Alessandro Dovis, Penn State and Princeton University IES; and Patrick Kehoe, Federal Reserve Bank of Minneapolis and NBER
The classic optimal currency area criterion is that countries with more correlated shocks are better candidates for forming a union. Chari, Dovis, and Kehoe show that when countries have credibility problems this simple criterion must be changed: symmetric countries gain credibility when joining the union only when the shocks affecting credibility are not highly correlated. The authors' analysis provides an amended optimal currency area criterion that they argue is more relevant than the classic one. They illustrate their argument both for a reduced form model and for a relatively standard sticky-price general equilibrium model. They argue that their new criterion should lead to a rethinking of the massive amount of empirical work on optimal currency areas.
Nicolas Coeurdacier, Sciences Po and CEPR; Helene Rey, London School Business and NBER; and Pablo Winant, Paris School of Economics