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.

Two papers on frictions in the business cycle

July 12, 2016

The last NEP-DGE report has two very interesting papers on frictions in the business cycle. I could not bring myself to feature only, so here are both. The first is interesting in that it can account for the movement of both the size and quantity of asset liquidity in the market through a cycle, the second in that it shows that the costless vacancy creation hypothesis in a typical labor search model has important implications, especially if you want to account for long recoveries.

Search-based endogenous asset liquidity and the macroeconomy

By Wei Cui and Sören Radde

We endogenize asset liquidity in a dynamic general equilibrium model with search frictions on asset markets. In the model, asset liquidity is tantamount to the ease of issuance and resaleability of private financial claims, which is driven by investors’ participation on the search market. Limited market liquidity of private claims creates a role for liquid assets, such as government bonds or at money, to ease financing constraints. We show that endogenising liquidity is essential to generate positive comovement between asset (re)saleability and asset prices. When the capacity of the asset market to channel funds to entrepreneurs deteriorates, investment falls while the hedging value of liquid assets increases, driving up liquidity premia. Our model, thus, demonstrates that shocks to the cost of financial intermediation can be an important source of flight-to-liquidity dynamics and macroeconomic fluctuations, matching key business cycle characteristics of the U.S. economy.

The slow job recovery in a macro model of search and recruiting intensity

By Sylvain Leduc and Zheng Liu

Despite steady declines in the unemployment rate and increases in the job openings rate after the Great Recession, the hiring rate in the United States has lagged behind. Significant gaps remain between the actual job filling and finding rates and those predicted from the standard labor search model. To examine the forces behind the slow job recovery, we generalize the standard model to incorporate endogenous variations in search intensity and recruiting intensity. Our model features a vacancy creation cost, which implies that firms rely on variations in both the number of vacancies and recruiting intensity to respond to aggregate shocks, in contrast to the textbook model with costless vacancy creation and thus constant recruiting intensity. Cyclical variations in search and recruiting intensity drive a wedge into the matching function even absent exogenous changes in match efficiency. Our estimated model suggests that fluctuations in search and recruiting intensity help substantially bridge the gap between the actual and model-predicted job filling and finding rates in the aftermath of the Great Recession.

The Welfare Effects of Involuntary Part-Time Work

July 8, 2016

By Daniel Borowczyk-Martins and Étienne Lalé

Employed individuals in the U.S. are increasingly more likely to work part-time involuntarily than to be unemployed. Spells of involuntary part-time work are different from unemployment spells: a full-time worker who takes on a part-time job suffers an earnings loss while remaining employed, and is unlikely to receive income compensation from publicly-provided insurance programs.We analyze these differences through the lens of an incomplete-market, job-search model featuring unemployment risk alongside an additional risk of involuntary part-time employment. A calibration of the model consistent with U.S. institutions and labor-market dynamics shows that involuntary part-time work generates lower welfare losses relative to unemployment. This finding relies critically on the much higher probability to return to full-time employment from part-time work. We interpret it as a premium in access to full-time work faced by involuntary part-time workers, and use our model to tabulate its value in consumption-equivalent units.

This paper is a bigger deal than it seems, and they is actual debate about this topic. It is matters quite a bit. People may not like it ti be working part-time, but the continuation value is so much higher than under unemployment. Of course, this result may not translate to other labor markets with different employment probabilities and different income support schemes.


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