Household Borrowing Constraints and Residential Investment Dynamics

September 14, 2016

By Hashmat Khan and Jean-François Rouillard

Why does residential investment lead output in the US and Canada but it is coincident in eurozone countries? In this paper we explore the role of home-equity loans used to boost consumption as a channel that affects residential investment. We consider a multi-agent model where some home-owning households face borrowing constraints that reflect home-equity loans or refinancing constraints. The main contribution of our paper is to highlight that the severity of the households’ borrowing constraints in an economy can generate both stylized facts of residential investment dynamics. In US and Canada, a greater proportion of households rely on home-equity loans relative to eurozone countries. This difference matters for the distinct residential investment dynamics observed across countries.

This paper puts an additional twist to the long-standing puzzle about residential investment leading the cycle in the US while non-residential investment is lagging in the US. The paper also reinforces that financial institutions do matter.

Marketmaking Middlemen

August 30, 2016

By Pieter Gautier, Bo Hu and Makoto Watanabe

This paper develops a model in which market structure is determined endogenously by the choice of intermediation mode. We consider two representative business modes of intermediation that are widely used in real-life markets: one is a middleman mode where an intermediary holds inventories which he stocks from sellers for the purpose of reselling to buyers; the other is a market-making mode where an intermediary offers a platform for buyers and sellers to trade with each other. In our model, buyers and sellers can simultaneously search in an outside market and use the intermediation service. We show that a marketmaking middleman, who adopts the mixture of these two intermediation modes, can emerge in a directed search equilibrium.

There is virtually no paper that endogenizes the matching mechanism in markets. This paper does it. It matters: many markets are transforming themselves as intermediation costs are getting slimmer, especially for peer-to-peer matches (think Uber, Amazon, discount brokers).

An Analysis of Consumer Debt Restructuring Policies

August 26, 2016

By Joao Cocco and Nuno Clara

We solve a quantitative dynamic model of borrower behavior, whose income is subject to individual specific and aggregate shocks. Lenders provide loans competitively. Recessions are characterized by lower expected earnings growth and a higher likelihood of a large drop in earnings. The model generates procyclical credit demand and countercyclical default. We analyze alternative debt restructuring policies aimed at reducing default during recessions: (i) interest rate reduction; (ii) maturity extension; and (iii) refinancing. Outcomes are best for the maturity extension policy that allows borrowers to temporarily make interest-only payments on the loan. Not all borrowers exercise the option. The maturity extension policy leads to lower default rates, higher consumer welfare, and a smaller drop in consumption during recessions, without significantly increasing cash-flow risk for lenders.

Thus, regulation should be more flexible in allowing for maturity extension. It looks, however, that this may be one of those situations where the interests of the lenders do not exactly align with those of the economy as a whole. But to look into this, one needs to take a stand in weighing consumer and lender welfare.

Self-Fulfilling Sovereign Debt Crises

August 10, 2016

By Mark Aguiar, Satyajit Chatterjee, Harold Cole and Zachary Stangebye

Sovereign debt spreads occasionally exhibit sharp, large spikes in spreads over risk-free bonds. We document that these movements are only weakly correlated with movements in domestic output and are frequently followed by reductions in the face value of debt outstanding. Motivated by this evidence, we propose a quantitative model with long-term bonds and three sources of risk: fluctuations in the growth of domestic income; movements in the risk premia associated with default risk; and shifts in creditor “beliefs” regarding the actions of other creditors. We show that the shifts in creditor beliefs directly play an important role in generating default risk, but also amplify the impact of shocks to fundamentals. Interestingly, persistent changes to risk premia have a negligible impact on spreads, and an increase in risk premium may even lead to a decline in spreads. The latter reflects that a higher risk premium provides discipline regarding future debt issuances. More generally, the sovereign borrowing decisions are quantitatively sensitive to equilibrium bond prices. Even large, relatively unexpected shocks to creditor beliefs have only a modest effect on spreads as the government responds by aggressively deleveraging.

This is an intriguing paper, in particular because it shows how market “sentiment” and by extension herd behavior can be critical. Volatile creditor beliefs have a clear welfare cost, but it is not clear to me what policy could reduce their volatility, apart from having a “credible” government.

Optimal Unemployment Insurance and International Risk Sharing

August 2, 2016

By Stéphane Moyen, Nikolai Stähler and Fabian Winkler

e discuss how cross-country unemployment insurance can be used to improve international risk sharing. We use a two-country business cycle model with incomplete financial markets and frictional labor markets where the unemployment insurance scheme operates across both countries. Cross-country insurance through the unemployment insurance system can be achieved without affecting unemployment outcomes. The Ramsey-optimal policy however prescribes a more countercyclical replacement rate when international risk sharing concerns enter the unemployment insurance trade-off. We calibrate our model to Eurozone data and find that optimal stabilizing transfers through the unemployment insurance system are sizable and mainly stabilize consumption in the periphery countries, while optimal replacement rates are countercyclical overall. Moreover, we find that debt-financed national policies are a poor substitute for fiscal transfers.

This is another attempt to realize within the EU what is already happening within some countries: regional risk sharing through flexibility in unemployment insurance eligibility and benefits. The theory, while complex, is still relatively simple compared to the politics that would be required for EU members to give up another layer of sovereignty for their own good. We know now that this is an uphill battle.

Recall and Unemployment

July 26, 2016

Shigeru Fujita and Guiseppe Moscarini

Using data from the Survey of Income and Program Participation (SIPP) covering 1990-2013, we document that a surprisingly large number of workers return to their previous employer after a jobless spell, and experience very different unemployment and employment outcomes than job switchers. Furthermore, the probability of recall is much less cyclical and volatile than the probability of finding a new job. Building on these facts, we introduce a recall option in a canonical search-and-matching business- cycle model of the labor market. The recall option is lost when the unemployed worker accepts a new job. New matches are mediated by a matching function, which brings together costly vacancy postings and costly search effort by unemployed workers. In contrast, recalls are frictionless and free, and triggered both by aggregate and job-specific shocks. A quantitative version of the model captures well our cross-sectional and cyclical facts through selection of recalled matches. Model analysis shows that recall and search effort significantly amplify the cyclical volatility of job finding and separation rates.

I suspect that the United States economy is rather unique in this high proportion of recall unemployment. But the logic of this may also matter elsewhere as recall is potentially an important outside option for any laid off worker. For the US, Fujita and Moscarini show that it matters indeed.

Reviving the limit cycle view of macroeconomic fluctuations

July 20, 2016

By Paul Beaudry, Dana Galizia and Franck Portier

There is a long tradition in macroeconomics suggesting that market imperfections may explain why economies repeatedly go through periods of booms and busts. This idea can be captured mathematically as a limit cycle. In this paper we present both a general structure and a particular model with the aim of giving new life to this mostly dismissed view of fluctuations. We begin by showing why and when models with strategic complementarities can give rise to unique-equilibrium dynamics characterized by a limit cycle. We then develop a fully-specified dynamic general equilibrium model that embeds a demand complementarity that allows for a limit cycle. Booms and busts arise endogenously in our setting because agents want to concentrate their purchases of goods at times when purchases by others are high, since in such situations unemployment is low and therefore taking on debt is perceived as being less risky. A key feature of our approach is that we allow limit-cycle forces to compete with exogenous disturbances in explaining the data. Our estimation results indicate that US business cycle fluctuations in employment and output can be well explained by endogenous demand-driven cycles buffeted by technological disturbances that render those fluctuations irregular.

This is going to be a controversial paper because it revisits theories that have been discredited, sometimes with choice words. Beaudry and Portier have successful in revisiting old theories or bringing distinct strands of literature together. We’ll whether this on does as well.