International Finance and Macroeconomics

October 31, 2014
Charles Engel, University of Wisconsin, Madison, and Emmanuel Farhi, Harvard University, Organizers

Seunghoon Na, Columbia University; Stephanie Schmitt-Grohé and Martin Uribe, Columbia University and NBER; and Vivian Yue, Federal Reserve Board

A Model of the Twin Ds: Optimal Default and Devaluation (NBER Working Paper No. 20314)

In this paper, Na, Uribe, Schmitt-Grohé, and Yue characterize jointly optimal default and exchange-rate policy. The theoretical environment is a small open economy with downward nominal wage rigidity as in Schmitt-Grohé and Uribe (2013) and limited enforcement of international debt contracts as in Eaton and Gersovitz (1981). It is shown that, under optimal policy, default is accompanied by large devaluations. At the same time, under fixed exchange rates, optimal default takes place in the context of large involuntary unemployment. Fixed-exchange-rate economies are found to be able to support less external debt than economies with optimally floating rates. In addition, the following three analytical results are presented: (1) Real economies with limited enforcement of international debt contracts in the tradition of Eaton and Gersovitz (1981) can be decentralized using capital controls. (2) Real economies in the tradition of Eaton and Gersovitz can be interpreted as the centralized version of models with downward nominal wage rigidity, optimal capital controls, and a full-employment exchange-rate policy. And (3) Full-employment is optimal in an economy with downward nominal wage rigidity, limited enforcement of debt contracts, and optimal capital controls.

Cristina Arellano, Federal Reserve Bank of Minneapolis and NBER, and Yan Bai, University of Rochester and NBER

Linkages Across Sovereign Debt Markets (NBER Working Paper No. 19548)

Arellano and Bai develop a multi-country model in which default in one country triggers default in other countries. Countries are linked to one another by borrowing from and renegotiating with common lenders. Countries default together because by doing so they can renegotiate the debt simultaneously and pay lower recoveries. Defaulting is also attractive in response to foreign defaults because the cost of rolling over the debt is higher when other countries default. Such forces are quantitatively important for generating a positive correlation of spreads and joint incidence of default. The model can rationalize some of the recent economic events in Europe as well as the historical patterns of defaults, renegotiations, and recoveries across countries.

Varadarajan Chari and Patrick Kehoe, University of Minnesota and NBER, and Alessandro Dovis, Pennsylvania State University

On the Optimality of Financial Repression

Financial repression is defined as regulation imposed by government to banks and other financial intermediary to force them to hold more government bonds than they would absent such regulation. Chari, Dovis, and Kehoe investigate when, if ever, financial repression is optimal. The researchers find that under commitment financial repression is never optimal. If, however, a government cannot commit to its policies, in particular it cannot commit to repaying its debt, then financial repression may be optimal. Moreover, the authors find that the more severe the fluctuations in spending needs, the stronger the financial repression when spending needs are high. They show that their model can broadly account for the pattern of repression in the United States post WWII.

Anton Korinek, Johns Hopkins University and NBER

International Spillovers and Guidelines for Policy Cooperation: A Welfare Theorem for National Economic Policymaking

In an interconnected world, national economic policies lead to international spillover effects. This has recently raised concerns about global currency wars. Korinek shows that international spillover effects are Pareto efficient and that there is no role for global coordination if three conditions are met: (i) national policymakers act as price-takers in the international market, (ii) national policymakers possess a complete set of instruments to control transactions with the rest of the world and (iii) international financial markets are complete. Under these conditions, international spillover effects constitute pecuniary externalities that are mediated through market prices and do not give rise to inefficiency. The researcher covers four applications: policies to correct growth externalities, aggregate demand externalities in a liquidity trap, spillovers from fiscal policy, and exchange rate stabilization policy. Conversely, if any of the three conditions Korinek identifies is violated, he shows how global cooperation can improve welfare. Examples that the author covers include beggar-thy-neighbor policies, countries with imperfect instruments, and incomplete global financial markets.

Luca Fornaro, CREI, Universitat Pompeu Fabra and Barcelona GSE

International Debt Deleveraging

In this paper, Fornaro provides a framework to understand debt deleveraging in a group of financially integrated countries. During an episode of international deleveraging, world consumption demand is depressed and the world interest rate is low, reflecting a high propensity to save. If exchange rates are allowed to oat, deleveraging countries can rely on depreciations to increase production and mitigate the fall in consumption associated with debt reduction. The key insight of the paper is that in a monetary union this channel of adjustment is shut off, because deleveraging countries cannot depreciate against the other countries in the monetary union, and therefore the fall in the demand for consumption and the downward pressure on the interest rate are amplified. Hence, deleveraging can easily push a monetary union against the zero lower bound and into a recession.

Marcos Chamon, International Monetary Fund; Julian Schumacher, Freie Universit├Ąt Berlin; and Christoph Trebesch, University of Munich

Foreign Law Bonds: Can They Reduce Sovereign Borrowing Costs?

The Greek debt restructuring of 2012 showed that the legal terms of sovereign bonds can protect creditors against losses, in particular the type of governing law. This paper studies whether sovereign bonds that are issued in foreign jurisdictions trade at a premium vis-á-vis domestic-law bonds. Chamon, Schumacher, and Trebesch use the Eurozone between 2007 and 2014 as a unique testing ground to assess this "legal safety premium" and collect secondary market bond yield data for the near-universe of Eurozone government bonds issued in foreign jurisdictions. Controlling for currency risk, liquidity risk, and term structure, the researchers find that foreign-law bonds indeed carry lower yields on average. But a sizable premium only emerges for large values of credit risk (CDS spreads beyond 500bp). At those levels, a 100 bp increase in CDS spreads is associated with a 30-80bp larger yield premium on foreign-law bonds. In contrast, the authors do not find a premium for countries that are perceived as low risk. These results indicate that sovereigns in distress can, at the margin, borrow at lower rates under foreign-law.

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