International Finance and Macroeconomics

Members of the NBER's International Finance and Macroeconomics Program met in Cambridge on October 25. Research Associates Guido Lorenzoni of Northwestern University and Vivian Yue of Emory University organized the meeting. These researchers' papers were presented and discussed:

Chenzi Xu, Harvard University

Reshaping Global Trade: The Immediate and Long-Run Effects of Bank Failures

Xu provides evidence from the most severe banking crisis in British history that financial shocks can have a long-lasting impact on the patterns of international trade. The setting for the study is the unexpected failure in May 1866 of Overend and Gurney, London's largest interbank lender. Overend's failure led to widespread bank runs in London that caused 12 percent of British multinational banks to fail. These multinational banks played a dominant role in financing international trade during the 19th century. Using detailed archival records, Xu documents that 10 percent exposure to these failed banks led to 5.6 percent fewer exports the following year. Strikingly, the impact on international trade patterns persisted for almost four decades despite a rapid recovery of the banking sector following the crisis. There was limited within-country substitution, leading to permanent divergence in exports levels across countries: those more exposed to bank failures had 1.8 percent lower annual export growth from 1866-1914. Countries that faced high export competition and those that had little access to alternative forms of credit experienced more persistent effects.

Jordi Galí, CREI and NBER

Uncovered Interest Parity, Forward Guidance and the Exchange Rate

Galí analyze the effectiveness of forward guidance policies in open economies, focusing on the role played by the exchange rate in their transmission. Under uncovered interest parity (UIP), the effect on the real exchange rate of an anticipated change in the real interest rate does not decline with the horizon. Empirical evidence using U.S., euro area and UK data points to a substantial deviation from that invariance prediction: expectations of interest rate differentials in the near (distant) future are shown to have much larger (smaller) effects on the real exchange rate than is implied by UIP. Some possible explanations are discussed.

Gabriel Chodorow-Reich, Harvard University and NBER; Loukas Karabarbounis, University of Minnesota and NBER; and Rohan Kekre, University of Chicago

The Macroeconomics of the Greek Depression (NBER Working Paper 25900)

The Greek economy experienced a boom until 2007, followed by a prolonged depression resulting in a 25 percent shortfall of GDP by 2016. Informed by a detailed analysis of macroeconomic patterns in Greece, Chodorow-Reich, Karabarbounis, and Kekre estimate a rich dynamic general equilibrium model to assess quantitatively the sources of the boom and bust. Lower external demand for traded goods and contractionary fiscal policies account for the largest fraction of the Greek depression. A decline in total factor productivity, due primarily to lower factor utilization, substantially amplifies the depression. Given the significant adjustment of prices and wages observed throughout the cycle, a nominal devaluation would only have short-lived stabilizing effects. By contrast, shifting the burden of adjustment away from taxes toward spending or away from capital taxes toward other taxes would generate longer-term production and consumption gains. Eliminating the rise in transfers to households during the boom would significantly reduce the burden of tax adjustment in the bust and the magnitude of the depression.

Javier Bianchi, Federal Reserve Bank of Minneapolis and NBER, and Cesar Sosa-Padilla, University of Notre Dame

Reserve Accumulation, Macroeconomic Stabilization and Sovereign Risk

Bianchi and Sosa-Padilla study the use of foreign reserves for macroeconomic stabilization purposes in a small open economy. Three key features characterize our model economy: (i) nominal rigidities, (ii) fixed exchange rates, and (iii) sovereign default risk. The researchers argue that these features are prevalent in a large number of emerging economies. In this setup, reserve accumulation not only serves a precautionary role (hedging against roll-over risk) but it is also useful for macro-stabilization goals: in bad times, when aggregate demand is low, involuntary unemployment arises and output is low, the country can use (i.e. run down) its reserves to boost aggregate demand and output. Bianchi and Sosa-Padilla study the country's optimal external portfolio composition (debt and reserves), how the stabilization property of reserves interacts with the typical precautionary role, and how this affects the country's default incentives.

Luis Cespedes, Universidad Adolfo Ibáñez, and Roberto Chang, Rutgers University and NBER

Optimal Foreign Reserves and Central Bank Policy Under Financial Stress

Cespedes and Chang study the interaction between optimal foreign reserves accumulation and central bank international liquidity provision in a small open economy under financial stress. Firms and households finance investment and consumption by borrowing from domestic financial intermediaries (banks), which in turn borrow from abroad. Binding financial constraints can cause the domestic rate of interest to raise above the world rate and the real exchange rate to depreciate, leading to inefficiently low investment and consumption. A role then emerges for a central bank that accumulates reserves in order to provide liquidity if financial frictions bind. The optimal level of international reserves in this context depends, among other variables, on the term premium, the depth of financial markets, ex ante financial uncertainty and the precise way the central bank intervenes. The model is consistent with both the increase in international reserves observed during the period 2004-2008 and with policy intervention after the Lehman bankruptcy.

Jeremy Fouliard, London Business School; Michael Howell, CrossBorder Capital; and Hélène Rey, London Business School and NBER

Answering the Queen: Machine Learning and Financial Crises

Financial crises cause economic, social and political havoc. Fouliard, Howell, and Rey use the general framework of sequential predictions also called online machine learning to forecast crises out-of-sample. Their methodology is based on model averaging and is "meta-statistic"since we can incorporate any predictive model of crises in our set of experts and test its ability to add information. They are able to predict systemic financial crises 12 quarters ahead in quasi-real time with very high signal to noise ratio. The researchers also analyse which models and variables provide the most information for their predictions at each point in time, allowing them to gain some insights into economic mechanisms underlying the building of risk in economies.

Wenxin Du, University of Chicago and NBER; Benjamin M. Hébert, Stanford University and NBER; and Amy Wang Huber, Stanford University

Are Intermediary Constraints Priced?

Violations of no-arbitrage conditions measure the shadow cost of constraints on intermediaries, and the risk that these constraints tighten is priced. Du, Hébert, and Wang Huber demonstrate in an intermediary-based asset pricing model that violations of no-arbitrage such as covered interest rate parity (CIP) violations, along with intermediary wealth returns, can be used to price assets. They describe a "forward CIP trading strategy" that bets on CIP violations becoming smaller, and show that its returns help identify the price of the risk that the shadow cost of intermediary constraints increases. This risk contributes substantially to the volatility of the stochastic discount factor, and appears to be priced consistently in U.S. treasury, emerging market sovereign bond, and foreign exchange portfolios.

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