Based on: The I Theory of Money - Redistributive Monetary Policy CFS Symposium: Banking, Liquidity, and Monetary Policy 26 September 2013, Frankfurt am Main 2013 FINANCIAL DOMINANCE MARKUS K. BRUNNERMEIER & YULIY SANNIKOV
Financial Dominance Fiscal dominance (FTPL) Inability or unwillingness of fiscal authorities to control long-run expenditure/gdp ratio Limits monetary authority to raise interest rate Financial dominance Inability or unwillingness of financial sector to absorb losses Refusal to issue new equity pay out in early phase of crisis Limits policy options for price stability & fiscal debt sustainab. Forces government to bail out Limits financial repression for financial sector to give strategic defense mechanism: be vulnerable not to take away strength through weakness 2
in a financial crisis Solvency losses and debt-overhang in the system need to be absorbed/redistributed Fiscal authority bailout by tax payer Monetary authority inflation nominal claim holders Bond holders Liquidity problem default Short-term government debt Short-term bank debt financial repression for fiscal authority (under MoD) banks buy long-term government debt and issue short-term debt are subject to rollover/liquidity risk Diamond-Rajan view disciplinary device 3
Interest Rate Risk Rollover Risk Who bears interest rate increase or rollover risk? Depends on Maturity of bonds AND Risk bearing capacity of holders of long-term bonds issues Financial Sector is Loss to Long-term bond + Financial sector transforms maturity Short-term bond well capitalized undercapitalized Empty insurance to financial sector to (gain to financial sector) to 4
Who insures whom against liquidity risk? The dual role of default-free long-term government bonds 1. insure governments (fiscal authority): But what if banks are undercapitalized? 2. insures banks (monetary authority): The I Theory of Money redistributive monetary policy Cut short-term interest rate buy bonds through OMO value of long-term bonds rises stealth recapitalization of banks 5
A Stylized Economy: without banks Future taxes - expenditures End-borrowers Savers Risky direct lending 9
A Stylized Economy Intermediaries are better in 1. Diversifying 2. Monitoring/enforcing End-borrowers Inside Riskier direct lending Savers 10
Adverse Shock split into 4 Steps 1. Shock impairs asset 2. Balance sheet shrink 3. Asset price 4. Real value of deposit End-borrowers Inside Riskier direct lending Savers 11
1. Shock Impairs Assets 1 st of 4 Steps End-borrowers Inside Savers Riskier direct lending 12
2. Shrink Balance Sheet: Sell off of Assets End-borrowers In- Savers More riskier direct lending 13
3. Liquidity Spiral: Sell off of Assets End-borrowers In- Savers Riskier direct lending 14
4. Deflation Spiral: Value of Liabilities Expands 1. Shock impairs asset 2. Balance sheet shrink 3. Asset price 4. Real value of deposit End-borrowers Savers Riskier direct lending Small shock has large effect and redistributes wealth 15
In sum, after an adverse shock are hit on both sides of the balance sheet Assets side: New credit supply Fire sales of assets asset price Investment Growth Liquidity spiral Financial instability Liability side: Deposits Deflation real value of debt Money multiplier Deflation spiral Price instability Response of banks to adverse shock leads to Amplification endogenous/systemic risk Persistence wealth redistribution Effects extent to other overly indebted sectors Japan 1980s: corporate sector US 2000s: Households 16
Introducing Monetary Policy Role of monetary policy Limit amplification and endogenous risk Limit/undo wealth redistribution due to endogenous risk Risk redistribution = wealth redistribution contingent on (tail) event Permanent losses Temporary shortage Liquidity policy Lender of Last Resort Contrast: Money View and View Switch off deflationary spiral vs. restore credit 18
Money View Restore supply Helicopter drop to savers Savers 19
Money View Restore supply Helicopter drop to savers reserves reserves Inside Savers 20
Money View Restore supply Switches off Deflationary spiral Bankers are better capitalized reserves Savers Slightly more credit BUT credit is not restored 21
View Restore healthy credit Not Zombie banks Not Vampire banks Inside Savers 22
View Restore healthy credit Not Zombie banks Not Vampire banks Recapitalization Gift to solvent banks Inside 23
View Restore healthy credit Not Zombie banks Not Vampire banks Recapitalization Gift to solvent banks Switches off Deflationary spiral Inside 24
View Restore healthy credit Not Zombie banks Not Vampire banks Recapitalization Gift to solvent banks Switches off Deflationary spiral Liquidity spiral Inside is restored, as banks are recapitalized Next, stealth recapitalization of banks 25
Monetary Policy in reality Outright purchase of bank loans (credit) Interest policy and OMO 26
Monetary Policy in reality Interest policy and OMO Introduce long-term Gov-bond Fixed interest rate No default Held by banks Value of long-term bond rises when short-term interest rate falls LT Bond LT Bond Inside Increases the supply of assets that can be used to store of value 27
Monetary Policy in reality Interest policy and OMO Introduce long-term Gov-bond Fixed interest rate No default Held by banks Value of long-term bond rises when short-term interest rate falls Increases the supply of assets that can be used to store of value Adverse shock value of credit/loans drops Monetary Policy Response: LT Bond LT Bond Inside 28
Monetary Policy in reality Interest policy and OMO Introduce long-term Gov-bond Fixed interest rate No default Held by banks Value of long-term bond rises when short-term interest rate falls Increases the supply of assets that can be used to store of value Adverse shock value of credit/loans drops LT Bond LT Bond Inside Monetary Policy Response: Cut short-term interest rate i t value of long-term bond rises - stealth recapitalization Liquidity & Deflationary Spiral are switched off 29
Ex-post Redistribution Undo redistribution which would be caused endogenously Redistribution is not a zero sum game! Welfare gain potentially to everyone 30
Ex-ante Monetary Policy Rule Insurance arrangement across sectors Completes markets Simple interest rate rule is not sufficient Target excessive credit spreads Moral Hazard limits implementable rules Combine with macro-prudential (quantitative) rules (LTV, haircuts, ) Punish the weak and strengthen the cautious within sector 31
Financial Stability Price Stability Debt Sustainability Financial Regulators LT Bond Inside Liquidity spiral Fisher Deflation spiral Central Bank Deflation Fiscal Authority Future taxes - expenditures LT Bond
Link: & Fiscal Debt Sustainability So far, Gov. bond default-free Now: fear of default MoPo might be impaired Fiscal dominance Unwillingness of governments to balance long-run budget Monetary dominance Unwillingness of central bank to print Financial dominance Unwillingness of banks to raise equity Future taxes - expenditures LT Bond LT Bond Inside 34
Financial Stability Price Stability Debt Sustainability Financial Regulators LT Bond Inside Liquidity spiral Fisher Deflation spiral Diabolic loop/spiral Central Bank Deflation Default Fiscal Authority GDP Fiscal dominance Future taxes - expenditures Monetary dominance LT Bond
Financial Stability Price Stability Debt Sustainability Financial Regulators LT Bond Inside Liquidity spiral Fisher Deflation spiral Diabolic loop/spiral Central Bank Deflation Inflation Default Fiscal Authority GDP Fiscal dominance Future taxes - expenditures Monetary dominance LT Bond
Opposing De- and Inflationary Forces Difficult to balance System is very unforgiving towards small mistakes Divergence in inflation expectations Possibly high inflation risk premium 38
Preventive Monetary Policy Early warning signals growth and imbalances Follow credit and monetary aggregates Volatility Paradox + Financial Innovation Quantity controls Through macro-prudential tools LTV, DTI, 39
Conclusion: Financial Dominance MoPo redistribute wealth ex-post, insurance ex-ante Interest rate policy and OMO affects value of long-term bond Who insures whom? governments or government banks Empty insurance against roll over risk Defense mechanism against financial repression? Stability concepts are highly interlinked Opposing de- & inflationary forces Difficult to balance Calls for preventative monetary and macro-prudential tools
Congrats Raghu! 42
New Keynesian I-Theory Key friction Price stickiness & ZLB Financial friction Role of Unit of account Store of value Driver Monetary policy implementation Demand driven as firms are obliged to meet demand at sticky price Optimal price setting over time Misallocation of funds (impaired balance sheets) Ex-ante insurance complete markets First order effects Affect HH s intertemporal trade-off Nominal interest rate impact real interest rate due to price stickiness Ex-post: redistributional effects Ex-ante: insurance Time consistency Substitution effect Wage stickiness Price stickiness + monopolistic competition Income effect Moral hazard in risk taking (bubbles) - Greenspan put - Yield curve Expectation hypothesis only Term/inflation risk premia 43