On the Instability of Banking and Other Financial Intermediation

July 8, 2019

By Chao Gu, Cyril Monnet, Ed Nosal and Randall Wright


Are financial intermediaries inherently unstable? If so, why? What does this suggest about government intervention? To address these issues we analyze whether model economies with financial intermediation are particularly prone to multiple, cyclic, or stochastic equilibria. Four formalizations are considered: a dynamic version of Diamond-Dybvig banking incorporating reputational considerations; a model with delegated investment as in Diamond; one with bank liabilities serving as payment instruments similar to currency in Lagos- Wright; and one with Rubinstein-Wolinsky intermediaries in a decentralized asset market as in Duffie et al. In each case we find, for different reasons, financial intermediation engenders instability in a precise sense.

Do financial intermediaries bring instability to the economy? This is a quite fundamental question, and policy makers seem to have responded with the affirmative given the amount of regulation that this sector is subject to. Are they right? This paper seems to suggest so, as four popular models of financial intermediation indicate.


Females, the elderly, and also males: Demographic aging and macroeconomy in Japan

July 7, 2019

By Sagiri Kitao, Minamo Mikoshiba and Hikaru Takeuchi


The speed and magnitude of ongoing demographic aging in Japan are unprecedented. A rapid decline in the labor force and a rising fiscal burden to finance social security expenditures could hamper growth over a prolonged period. We build a dynamic general equilibrium model populated by overlapping generations of males and females who differ in employment type and labor productivity as well as life expectancy. We study how changes in the labor market over the coming decades will affect the transition path of the economy and fiscal situation of Japan. We find that a rise in the labor supply of females and the elderly of both genders in an extensive margin and in labor productivity can significantly mitigate effects of demographic aging on the macroeconomy and reduce fiscal pressures, despite a decline in wage during the transition. We also quantify effects of alternative demographic scenarios and fiscal policies. The study suggests that a combination of policies that remove obstacles hindering labor supply and that enhance a more efficient allocation of male and female workers of all age groups will be critical to keeping government deficit under control and raising income across the nation.

Japan should be more studied because it is a real-life laboratory of what is going to happen to other industrialized economies. First, it experienced from the 1990s a long period of very low interest rates, which other countries got to experience in the last ten years. Second, it is right now going through a very significant ageing transition of its population, which will soon happen as the Boomers retire in Western Europe and North America. This paper shows what to expect, in particular some endogenous responses of the labor force that we typically assume out of our models.

Reassessing Trade Barriers with Global Value Chains

June 5, 2019

Yuko Imura


This paper provides a systematic, quantitative analysis of the short-run and long-run effects of various trade-restricting policies in the presence of global value chains and multinational production. Using a two-country dynamic stochastic general equilibrium model with endogenous firm entry and exit in both exporting and multinational production, I compare the effects of (i) tariffs on final-good imports, (ii) tariffs on intermediate-input imports, and (iii) barriers to accessing foreign markets. I show that, in the long run, all three policies lead to a recession in both countries, but the relative effects on the GDP of the two countries vary across policies. At the firm level, less productive exporters exit from the destination market while the most productive few find it profitable to locate production in the foreign country as multinationals, thereby partially recovering the loss from exporting. In the short run, the dynamics differ across policies and from their long-run outcomes. Final-good tariffs and market-access barriers lead to a temporary production boom in the policy-imposing country, while intermediate-input tariffs result in an immediate recession in both countries. The latter also discourages multinational operation over the short run when the input tariffs dominate the declining costs of labor and capital.

Offered without comment.

Employment protection reform in European labor markets: the collective bargaining regime matters.

May 30, 2019

By Francesco De Palma and Yann Thommen


Policy advisers repeatedly call on Western European countries to reform their employment protection legislation (EPL) by adopting layoff taxes to finance unemployment insurance (UI). This new design, partly based on the existing “experience-rating” (ER) system in the U.S., would induce firms to internalize layoff fiscal costs and hence reduce unemployment. Its success remains uncertain in economies with a collective wage-setting system, as in many Western European countries. Using a matching model with endogenous job destruction, we provide an ex-ante evaluation of this policy reform’s effects on labor market outcomes in a firm-level bargaining economy and a sector-level bargaining one. Using numerical exercises, we show that compared to a scenario of a simple increase in EPL stringency, the implementation of an ER system results in a decrease in unemployment under both bargaining regimes. Because of the possibility for firms to adjust most terms and conditions of employment (including wage) in decentralized negotiations, juxtaposing the ER system with the existing EPL yields the best labor market performance under a firm-level bargaining regime. The lack of internal flexibility in sector-level bargaining calls for accompanying the implementation of the ER with a relaxation of the existing EPL’s stringency. Lastly, we show that in industries with a turbulent economic environment, accompanying the introduction of ER while reducing the existing EPL’s strictness is recommended.

It seems obvious, like in any insurance problem with moral hazard, experience rating can only improve unemployment insurance. But, as the authors point us, other factors come into play in general equilibrium. It turns out experience rating is still a good idea for Europe while doing the kind of employment policy reform that is usually recommended anyway.

Leverage and Deepening Business Cycle Skewness

May 13, 2019

By Henrik Jensen, Ivan Petrella, Soren Ravn and Emiliano Santoro


We document that the U.S. and other G7 economies have been characterized by an increasingly negative business cycle asymmetry over the last three decades. This finding can be explained by the concurrent increase in the financial leverage of households and firms. To support this view, we devise and estimate a dynamic general equilibrium model with collateralized borrowing and occasionally binding credit constraints. Improved access to credit increases the likelihood that financial constraints become non-binding in the face of expansionary shocks, allowing agents to freely substitute intertemporally. Contractionary shocks, on the other hand, are further amplified by drops in collateral values, since constraints remain binding. As a result, booms become progressively smoother and more prolonged than busts. Finally, in line with recent empirical evidence, financially-driven expansions lead to deeper contractions, as compared with equally-sized non-financial expansions.

The paper makes a lot of sense, yet I am feeling uneasy about it. Can we really conclude that there is a new trend based on a handful of data points (recessions)? Usually, we ask for more data to say something has changed in the economy. Of course, this is a criticism that is not specific to this paper.

Firm and Worker Dynamics in an Aging Labor Market

May 10, 2019

By Niklas Engbom


I develop an idea flows theory of firm and worker dynamics in order to assess the consequences of population aging. Older people are less likely to attempt entrepreneurship and switch employers because they have found better jobs. Consequently, aging reduces entry and worker mobility through a composition effect. In equilibrium, the lower entry rate implies fewer new, better job opportunities for workers, while the better matched labor market dissuades job creation and entry. Aging accounts for a large share of substantial declines in firm and worker dynamics since the 1980s, primarily due to equilibrium forces. Cross-state evidence supports these predictions.

In retrospect, the central idea of the paper makes a lot of sense. Does the aging of the population do any good?

Making Carbon Taxation a Generational Win Win

May 2, 2019

By Laurence J. Kotlikoff, Felix Kubler, Andrey Polbin, Jeffrey D. Sachs and Simon Scheidegger


Carbon taxation has been studied primarily in social planner or infinitely lived agent models, which trade off the welfare of future and current generations. Such frameworks obscure the potential for carbon taxation to produce a generational win-win. This paper develops a large-scale, dynamic 55-period, OLG model to calculate the carbon tax policy delivering the highest uniform welfare gain to all generations. The OLG framework, with its selfish generations, seems far more natural for studying climate damage. Our model features coal, oil, and gas, each extracted subject to increasing costs, a clean energy sector, technical and demographic change, and Nordhaus (2017)’s temperature/damage functions. Our model’s optimal uniform welfare increasing (UWI) carbon tax starts at $30 tax, rises annually at 1.5 percent and raises the welfare of all current and future generations by 0.73 percent on a consumption-equivalent basis. Sharing efficiency gains evenly requires, however, taxing future generations by as much as 8.1 percent and subsidizing early generations by as much as 1.2 percent of lifetime consumption. Without such redistribution (the Nordhaus “optimum”), the carbon tax constitutes a win-lose policy with current generations experiencing an up to 0.84 percent welfare loss and future generations experiencing an up to 7.54 percent welfare gain. With a six-times larger damage function, the optimal UWI initial carbon tax is $70, again rising annually at 1.5 percent. This policy raises all generations’ welfare by almost 5 percent. However, doing so requires levying taxes on and giving transfers to future and current generations ranging up to 50.1 percent and 10.3 percent of their lifetime consumption. Delaying carbon policy, for 20 years, reduces efficiency gains roughly in half.

As has been amply documented in the news during the last months, concern about climate change is to a large extend a generational issue. To win over the older generation, the deal needs to be sweetened for them. This paper shows how. An important step, though, it to get them to understand carbon pricing, which may be an even bigger challenge.