Edgeworth Lecture 2016

Transcription

1 Edgeworth ecture 2016 Markus K. Brunnermeier Galeway, Ireland, May 6 th, 2016

2 based on Euro and the Battle of Ideas With Harold James & Jean-Pierre andau The I Theory of Money With Yuliy Sannikov Financial Dominance Baffi ecture 2015 Safe ssets With Valentin Haddad Euronomics Group 3

3 GDP accumulated since Euro Source: EuroStat 4

4 Overview Power shift watershed moments Rationale for focus on Germany and France Cultures Clash Different economic philosophies Ideas versus interest Shifts and reversals are possible Maastricht s Ghost: Monetary and fiscal stability Maastricht s Stepchild: Financial stability Paradox of Prudence Redistributive Monetary Policy Diabolic loop, flight to safety, ESBies 7

5 Watershed Moments/Turning Points 2010, May: EFSF, IMF involvement 2010, Oct: Deauville PSI: contagion 2 Power shifts 2012: Draghi s Whatever it takes Speech in ondon 2013: Cyprus Bail-in 8

6 German-French differences Interests are interpreted through the lens of ideas models

7 Difference in eco-philosophies: Historical roots Walter Bagehot (1869) In that case, there would be one Teutonic money and one atin money; the latter mostly confined to the West of Europe, and the former circulating through the world. Such a monetary state would be an immense improvement on the present. Yearly one nation after another would drop into the union which best suited it; and looking to the commercial activity of the Teutonic races, and the comparative torpor of the atin races, no doubt the Teutonic money would be most frequently preferred.

8 Ghost of Maastricht Rhine Divide French German 1. Discretion Rules 2. Solidarity iability Fiscal union No-bailout clause/rule 3. iquidity/contagion Solvency 4. Keynesian Stimulus usterity/reform 19

9 Unchangeable or fickle? Historic breaks and reversals in 1945 Germany moves from cameralism and state tradition to Ordoliberalism France moves from laissez faire to planisme lexis de Tocqueville: a people so unchangeable in its leading features that it may be recognized by portraits drawn two or three thousand years ago, and yet so fickle in its daily opinions and tastes that it becomes at last a mystery to itself. The ncien Regime and the French Revolution

10 Ghost of Maastricht Rhine Divide Black-white Organizing Principle French German 1. Discretion vs. Rules flexible crisis management ad hocery Problem with flexibility: Time-inconsistency ex-post ex-ante efficiency Price stability Financial stability Fiscal sustainability promise not to inflate in the future promise only to provide liquidity but not to bail-out (redistribute) insolvent institutions promise not to default on debt to spend in recessions (now) but consolidate (later) 21

11 Ghost of Maastricht Rhine Divide Black-white Organizing Principle French German 1. Discretion vs. Rules flexible crisis management ad hocery Problem with flexibility: Time-inconsistency ex-post ex-ante efficiency Price stability Financial stability Fiscal sustainability promise not to inflate in the future promise only to provide liquidity but not to bail-out (redistribute) insolvent institutions promise not to default on debt to spend in recessions (now) but consolidate (later) 22

12 Ghost of Maastricht Rhine Divide Black-white Organizing Principle French German 1. Discretion vs. Rules flexible crisis management ad hocery Problem with flexibility: Time-inconsistency ex-post ex-ante efficiency Price stability Financial stability Fiscal sustainability promise not to inflate in the future promise only to provide liquidity but not to bail-out (redistribute) insolvent institutions promise not to default on debt to spend in recessions (now) but consolidate (later) 23

13 Ghost of Maastricht Rhine Divide Black-white Organizing Principle French German 1. Discretion vs. Rules flexible crisis management ad hocery Problem with flexibility: Time-inconsistency Rules should fix commitment problems, but can t deal with unforeseen contingencies ristotle: Nicomachean Ethic V When the law speaks universally, and a case arises on it which is not covered by the universal statement, then it is right, where the legislator fails us and has erred by oversimplicity, to correct the omission-to say what the legislator himself would have said had he been present, and would have put into his law if he had known. Delegation: Institutional Design 24

14 Ghost of Maastricht Rhine Divide Black-white Organizing Principle French German 1. Discretion vs. Rules Time-inconsistency problem btw ex-post ex-ante efficiency Rules, but unforeseen contingencies Institutional Design (mechanism design) Fiscal authority Fiscal dominance Monetary dominance Financial dominance Be strategically weak! Game of chicken split Central Bank 25

15 Ghost of Maastricht Rhine Divide Black-white Organizing Principle French German 1. Discretion vs. Rules Time-inconsistency problem btw ex-ante ex-post efficiency Institutional Design (mechanism design) Fiscal authority recap Game of chicken split 2 nd Game of chicken Financial Sector Central Bank Redistributive MoPo (i, QE,.) 26

16 Ghost of Maastricht Rhine Divide Black-white Organizing Principle French German 1. Discretion Rules 2. Solidarity iability Fiscal union Illusion of default free bonds No-bailout clause/rule SDRM/insolvency procedures 27

17 Ghost of Maastricht Rhine Divide Black-white Organizing Principle French German 1. Discretion Rules 2. Solidarity iability Fiscal union Illusion of default free bonds No-bailout clause/rule SDRM/insolvency procedure 28

18 Ghost of Maastricht Rhine Divide Black-white Organizing Principle French German 1. Discretion Rules 2. Solidarity iability Fiscal union Illusion of default free bonds Eurobonds with joint liability No-bailout clause/rule SDRM/insolvency procedure ESBies without joint liability 29

19 Ghost of Maastricht Rhine Divide Black-white Organizing Principle French German 1. Discretion Rules 2. Solidarity iability 3. iquidity/contagion Solvency multiple equilibria big bazooka p S D E[NPV]>0, at what discount rate? 30

20 Ghost of Maastricht Rhine Divide Black-white Organizing Principle French German 1. Discretion Rules 2. Solidarity iability 3. iquidity/contagion Solvency multiple equilibria big bazooka p S D E[NPV]>0, at what discount rate? 31

21 Ghost of Maastricht Rhine Divide Black-white Organizing Principle French German 1. Discretion Rules 2. Solidarity iability 3. iquidity/contagion Solvency multiple equilibria big bazooka amplification/spirals E[NPV bailout]>0 E[PV bailout PV no bailout]>0 contagion/systemic Bail-out/Rin Countries Financial Sector p p E[NPV]>0, at what discount rate? Bail-in 32

22 Ghost of Maastricht Rhine Divide Black-white Organizing Principle French German 1. Discretion Rules 2. Solidarity iability fiscal union No-bailout clause/rule 3. iquidity/contagion Solvency 4. Keynesian Stimulus usterity/reform Demand Supply Output gap Reforms in boom unsustainable credit boom Reforms in crisis (political economy) 33

23 nglo-merican Thinking Close to French view, but Role of the government French Planning vs. US crisis management Default free debt vs. contingent debt smoothing smoothing + insurance bankruptcy law Main difference to German view Demand vs. Supply: Reforms during booms vs. in crisis Political economy difference Contingent debt on bad vs. extremely bad crisis states 35

24 Overview Power shift watershed moments Rationale for focus on Germany and France Cultures Clash Different economic philosophies Ideas versus interest Shifts are possible Maastricht s Ghost: Monetary and fiscal stability Maastricht s Stepchild: Financial stability Paradox of Prudence Redistributive Monetary Policy Diabolic loop, flight to safety, ESBies 37

25 Inside equity Risky Claim Risky Claim Risky Claim HH Net worth Risky Claim Risky Claim Risky Claim I Theory: Money and Banking Outside Money Pass through Outside Money Money Inside Money (deposits) Money B 1 Net worth 1 Intermediaries Can hold outside equity & diversify within sector b Monitoring Create inside money Maturity/liquidity transformation

26 I Theory: Money and Banking Money Banking store of value (less transaction role, unit of account) diversifier holds risky assets, issues inside money mplification/endogenous risk dynamics Value of capital declines due to Fire-sales Flight to safety Value of money rises iquidity spiral Disinflation spiral a la Fisher Demand for money rises less idiosyncratic risk is diversified Supply for inside money declines less creation by intermediaries Endogenous money multiplier = f(capitalization of critical sector) Paradox of Thrift (in risk terms) Monetary Policy (redistributive)

27 I Theory: Money and Banking Money Banking store of value diversifier holds risky assets, issues inside money mplification/endogenous risk dynamics Value of capital declines due to Fire-sales Flight to safety Value of money rises iquidity spiral Disinflation spiral a la Fisher Demand for money rises less idiosyncratic risk is diversified Supply for inside money declines less creation by intermediaries Endogenous money multiplier = f(capitalization of critical sector) Paradox of Thrift (in risk terms) Monetary Policy (redistributive)

28 Inside equity Risky Claim Risky Claim HH Net worth Risky Claim Risky Claim Risky Claim Shock impairs assets: 1 st of 4 steps Outside Money Pass through Money Inside Money (deposits) B 1 Net worth osses Money 1

29 Inside equity Risky Claim Risky Claim HH Net worth Risky Claim Risky Claim Risky Claim Shrink balance sheet: 2 nd of 4 steps Deleveraging Deleveraging Money Outside Money Pass through Inside Money Inside Money (deposits) (deposits) B 1 1 Net worth osses Money 1

30 Inside equity Risky Claim Risky Claim HH Net worth Risky Claim Risky Claim Risky Claim iquidity spiral: asset price drop: 3 rd of 4 Deleveraging Deleveraging Money Outside Money Pass through Inside Money Inside Money (deposits) (deposits) B 1 1 Net worth osses Money 1

31 Inside equity Risky Claim Risky Claim HH Net worth Risky Claim Risky Claim Risky Claim Disinflationary spiral: 4 th of 4 steps Deleveraging Deleveraging Money Outside Money Pass through Inside Money Inside Money (deposits) (deposits) B 1 1 Net worth osses Money 1

32 Paradox of Prudence Money Banking store of value diversifier holds risky assets, issues inside money mplification/endogenous risk dynamics Value of capital declines due to Fire-sales Flight to safety Value of money rises iquidity spiral Disinflation spiral a la Fisher Demand for money rises less idiosyncratic risk is diversified Supply for inside money declines less creation by intermediaries Endogenous money multiplier = f(capitalization of critical sector) Paradox of Thrift (in risk terms) Monetary Policy (redistributive)

33 Paradox of Prudence Money Banking store of value diversifier holds risky assets, issues inside money mplification/endogenous risk dynamics ributive) Value of capital declines due to Fire-sales Flight to safety Value of money rises iquidity spiral Disinflation spiral a la Fisher Demand for money rises less idiosyncratic risk is diversified Supply for inside money declines less creation by intermediaries Endogenous money multiplier = f(capitalization of critical sector) Paradox of Prudence Paradox of Thrift (in risk terms) Each banks tries to be reduce risk to be micro-prudent eads to more endogenous macro-risk

34 Introducing a Safe asset Safe asset = good friend It s there when you need it. Outside Money Pass through there = liquid/high price Safe asset Risky claims Inside Money (deposits) Net worth In bad times: risky claims lose in value safe asset appreciates exactly then wouldn t it be nice? ong-term (default-free) government bond & appropriate MoPo 48 N t

35 Ex-post: Redistributive MoPo Outside Money Pass through Bonds b t K t Risky claims Inside Money (deposits) Net worth N t dverse shock value of risky claims drops Monetary policy Interest rate cut long-term bond price sset purchase asset price stealth recapitalization - redistributive risk premia iquidity & Deflationary Spirals are mitigated

36 Ex-ante: MoPo as insurance MacroPru Ex-ante: insurance Negative shock: positive wealth transfer to bottleneck Positive shock: negative MoPo substitutes in for missing market But moral hazard excessive risk taking case for macro-prudential regulation 50

37 Role of Government bond Special MoPo Role: Default-free long-term gov. bond Interest rate policy leads to income/wealth effects (not only substitution effects) Insurance role for extreme crisis states Defaultable bond contingent debt tension French view never default (straight jacket commitment) (use banks as hostage) 54

38 Role of Government bond Special MoPo Role: Default-free long-term gov. bond Interest rate policy leads to income/wealth effects (not only substitution effects) Insurance role for extreme crisis states Defaultable bond contingent debt tension French view never default (straight jacket commitment) (use banks as hostage) German view Default in extreme circumstances imit banks sovereign risk taking 55

39 Government Debt: Toy Model t = 1 Refinance outstanding debt (from t = 0) Determines face value of new debt Default costs t = 2 uncertainty realizes -- state space 1. x = GDP: Economic activity income of citizens 2. x = Primary surplus: absent austerity measures/extra taxes 0 Tax revenue (normal regime) x 1/x Repay debt Extra austerity measures/taxes to cover shortfall Default decision

40 Government Debt imited commitment: verification cost Risk-neutral investors Face value Payoff of debt claim in t = Face value 0 0 Tax revenue (normal regime) x 1/x

41 Government Debt imited commitment: verification cost Risk-neutral investors Face value Payoff of debt claim in t = Face value 0 0 default probability Tax revenue (normal regime) x 1/x

42 Government Debt imited commitment: verification cost Risk-neutral investors Face value Payoff of debt claim in t = Contingent debt Partial default in bad states Face value 0 0 default probability Tax revenue (normal regime) x 1/x

43 Government Debt imited commitment: verification cost Risk-neutral investors Face value Payoff of debt claim in t = Face value Face value 0 0 default probability Tax revenue (normal regime) x 1/x Refinancing Potential t = 1

44 Government Debt imited commitment: verification cost Risk-neutral investors Face value Payoff of debt claim in t = Face value Face value 0 0 default probability Tax revenue (normal regime) x 1/x Refinancing Potential t = 1

45 Government Debt imited commitment: verification cost Risk-neutral investors Face value Payoff of debt claim in t = Face value Face value 0 0 default probability Tax revenue (normal regime) x 1/x solvent Refinancing Potential t = 1 insolvent

46 Government Debt imited commitment: verification cost Risk-neutral investors Face value Payoff of debt claim in t = Face value Face value 0 0 default probability Tax revenue (normal regime) x 1/x solvent illiquidity Refinancing Potential t = 1 insolvent

47 Government Debt imited commitment: verification cost Risk-neutral investors Face value Payoff of debt claim in t = Face value 1 + r B Face value 0 0 default probability Tax revenue (normal regime) x 1/x solvent illiquidity 1 + r B 1 Refinancing Potential t = 1 insolvent

48 Straight Jacket Commitment Face value 1 1 Face value 0 0 Tax revenue (normal regime) x 1/x

49 Straight Jacket Commitment Face value Face value 1 1 Face value 0 0 Tax revenue (normal regime) x 1/x solvent always liquidity Refinancing Potential t = 1 insolv.

50 Straight Jacket Commitment but tax short-fall Needs to raise taxes/austerity: distortionary costs in catastrophe states Face value Face value but. shortfall 1 1 Face value 0 0 Tax revenue (normal regime) x 1/x solvent always liquidity Refinancing Potential t = 1 insolv.

51 Straight Jacket Commitment Shortfall needs to be financed through usterity measures Emergency tax hikes τ(x F) F x 1/x For very low realizations of x these costs might go to infinity

52 Costly Commitment Default if austerity costs + repayment exceed C + x Default if τ x F + F > C + x τ(x F) C + x F F default probability default austerity x 1/x

53 Bailout Diabolic oop Trigger: fiscal or financial Sovereign debt risk Sovereign debt oans to economy Banks Deposits Equity Bailout cost Financial dominance increases commitment costs!

54 Bank Hostage Commitment Default if austerity costs + repayment exceed C + x Default if τ x F + F > C + x Increase commitment costs C τ(x F) ower default probability C + x F F 1/x default austerity x default probability

55 Bank Hostage Commitment Default if austerity costs + repayment exceed C + x Default if τ x F + F > C + x Increase commitment costs C C + x F τ(x F) ower default probability ower verification cost ower face value F interest rate F 1/x default austerity x

56 Bank Hostage Commitment Default if austerity costs + repayment exceed C + x Default if τ x F + F > C + x Increase commitment costs C C + x F τ(x F) F 1/x ower default probability ower verification cost ower face value F interest rate gain ower default probability default austerity x

57 Bank Hostage Commitment Default if austerity costs + repayment exceed C + x Default if τ x F + F > C + x Increase commitment costs C C + x F τ(x F) F 1/x ower default probability ower verification cost ower face value F interest rate gain ower default probability default austerity x Default prob doubling up strategy, but if: higher cost C & higher austerity τ

58 Credit Diabolic oop: overturns argument ess lending to real economy Sovereign debt risk Sovereign debt oans to economy Banks Deposits Equity TRO starts Economic growth Tax revenue Bailout cost GDP and tax revenue declines by τψ 0

59 Credit Diabolic oop Default if austerity costs + repayment exceed C + x Default if τ x F + F > C + x Increase commitment costs C τ(x F) owers GDP, x C + x F F 1/x default austerity x

60 Credit Diabolic oop Default if austerity costs + repayment exceed C + x Default if τ x F + F > C + x Increase commitment costs C τ(x F) owers GDP, x Default probability rises C + x F F 1/x default austerity x

61 Credit Diabolic oop Default if austerity costs + repayment exceed C + x Default if τ x F + F > C + x Increase commitment costs C τ(x F) owers GDP, x Default probability rises C + x F F 1/x Verification costs rise Face value F rises interest rate rises default austerity x

62 Credit Diabolic oop Default if austerity costs + repayment exceed C + x Default if τ x F + F > C + x Increase commitment costs C τ(x F) owers GDP, x Default probability rises C + x F F 1/x Verification costs rise Face value F rises interest rate rises default austerity x 2 nd Credit/GDP Diabolic oop can undo all the benefits Bank hostage is not even a doubling up strategy

63 Bank Hostage Commitment Extremely high commitment cost C due financial dominance straight jacket commitment Reduces illiquidity problems ower default prob., lower interest rate, but if failure then much worse doubling up strategy & but 2 nd Diabolic oop goes in opposite direction No safety valve

64 The two safe asset challenges Challenge 1: Safe asset + sovereign debt restructuring w/o diabolic loop French IMF/nglo-merican/German Challenge 2: No asymmetrically supplied safe asset German Bund 85

65 Cross-border flight to safety Today: asymmetric shifts across borders Value of German debt increases German CDS spread rises, but yield on bund drops (flight to quality) Value of Italian/Spanish/Greek sovereign debt declines With ESBies: Negative co-movement Value of ESBies expands Value of Junior bond shrinks sset side is more stable due to flight to quality due to increased risk 86

66 Solution: ESBies sovereign bonds ESBies Junior Bond Today: asymmetric shifts across borders Value of German debt increases German CDS spread rises, but yield on bund drops (flight to quality) Value of Italian/Spanish/Greek sovereign debt declines With ESBies: Negative co-movement across tranches Value of ESBies expands Value of Junior bond shrinks sset side is more stable due to flight to quality due to increased risk 87

67 Maastricht s Ghost: Fiscal & Monetary French German 1. Discretion Rules 2. Solidarity iability Fiscal union Illusion of default free bonds Eurobonds with joint liability 3. iquidity/contagion Solvency No-bailout clause/rule SDRM/insolvency procedure (ESBies) without joint liability 4. Keynesian Stimulus usterity/reform Demand Supply Output gap Reforms in boom unsustainable credit boom Reforms in crisis (political economy) 89

68 Maastricht s Stepchild: Financial French German 5. Bailout banks Bail-in illiquidity insolvency 6. No default illusion Debt restructuring zero risk weights diabolic loop as straight jacket commitment banks as hostage positive Basel risk weights avoid diabolic loop with sufficient equity 90

69 Conclusion policy implications Transfers without Politics: Insurance as a way of making automatic stabilizers? The insurance principle and predictability Support and solidarity need to be credible, i.e. based on consistent rules Sovereign Debt restructuring mechanism for Europe ESBies as safe asset for Europe Without default risk Without joint liability Break diabolic loop European Banking charter Tax revenue for European budget European bailout 91