Financial Regulation and Shadow Banking: A Small-Scale DSGE Perspective

September 13, 2017

By Patrick Fève and Olivier Pierrard

In this paper, we revisit the role of regulation in a small-scale dynamic stochastic general equilibrium (DSGE) model with interacting traditional and shadow banks. We estimate the model on US data and we show that shadow banking interferes with macro-prudential policies. More precisely, asymmetric regulation causes a leak towards shadow banking which weakens the expected stabilizing effect. A counterfactual experiment shows that a regulation of the whole banking sector would have reduced investment fluctuations by 10% between 2005 and 2015. Our results therefore suggest to base regulation on the economic functions of financial institutions rather than on their legal forms.

Regulators and banks play a cat and mouse game, and I wonder whether to adopt a rule like “if it looks like a bank, regulate as a bank” would work. But this is a good attempt at tackling the shadow banking sector, which is difficult to track properly both in real life and as a modeler.


Goods and Factor Market Integration: A Quantitative Assessment of the EU Enlargement

September 7, 2017

By Lorenzo Caliendo, Luca David Opromolla, Fernando Parro and Alessandro Sforza

The economic effects from labor market integration are crucially affected by the extent to which countries are open to trade. In this paper we build a multi-country dynamic general equilibrium model with trade in goods and labor mobility across countries to study and quantify the economic effects of trade and labor market integration. In our model trade is costly and features households of different skills and nationalities facing costly forward-looking relocation decisions. We use the EU Labour Force Survey to construct migration flows by skill and nationality across 17 countries for the period 2002-2007. We then exploit the timing variation of the 2004 EU enlargement to estimate the elasticity of migration flows to labor mobility costs, and to identify the change in labor mobility costs associated to the actual change in policy. We apply our model and use these estimates, as well as the observed changes in tariffs, to quantify the effects from the EU enlargement. We find that new member state countries are the largest winners from the EU enlargement, and in particular unskilled labor. We find smaller welfare gains for EU-15 countries. However, in the absence of changes to trade policy, the EU-15 would have been worse off after the enlargement. We study even further the interaction effects between trade and migration policies and the role of different mechanisms in shaping our results. Our results highlight the importance of trade for the quantification of the welfare and migration effects from labor market integration.

Trade in goods and movement of labor are substitutes. Opening trade and labor may thus introduce complex interactions. This paper tries to sort that out in general equilibrium, and it turns out everyone wins, although not necessarily a lot.

Banking Panics and Output Dynamics

September 1, 2017

By Daniel Sanches

This paper develops a dynamic general equilibrium model with an essential role for an illiquid banking system to investigate output dynamics in the event of a banking crisis. In particular, it considers the ex-post efficient policy response to a banking crisis as part of the dynamic equilibrium analysis. It is shown that the trajectory of real output following a panic episode crucially depends on the cost of converting long-term assets into liquid funds. For small values of the liquidation cost, the recession associated with a banking panic is protracted as a result of the premature liquidation of a large fraction of productive banking assets to respond to a panic. For intermediate values, the recession is more severe but short-lived. For relatively large values, the contemporaneous decline in real output in the event of a panic is substantial but followed by a vigorous rebound in real activity above the long-run level.

Hmm, Daniel Sanches is onto something here. Could the high level of financial development be the reason it took so long for the United States to get out of the last banking crisis? Eyeballing the graphs, it looks like the total cost of a banking crisis recession is higher if liquidation is less costly. That seems to be a surprising and counter-intuitive result, as large financial frictions seem to be better. And I wonder whether the steady-state effect of liquidation costs is stronger than the cyclical effect. So many questions…

Dynastic Precautionary Savings

August 29, 2017

By Corina Boar

This paper demonstrates that parents accumulate savings to insure their children against income risk. I refer to these as dynastic precautionary savings. Using a sample of matched parent-child pairs from the Panel Study of Income Dynamics, I test for dynastic precautionary savings by examining the response of parental consumption to the child’s permanent income uncertainty. I exploit variation in permanent income risk across age and industry-occupation groups to confirm that higher uncertainty in the child’s permanent income depresses parental consumption. In particular, I find that the elasticity of parental consumption to child’s permanent income risk ranges between -0.08 and -0.06, and is of similar magnitude to the elasticity of parental consumption to own income risk. Motivated by the empirical evidence, I analyze the implications of dynastic precautionary saving in a quantitative model of altruistically linked overlapping generations. I use the model to (i) examine the size and timing of inter-vivos transfers and bequest, (ii) perform counterfactual experiments to isolate the contribution of dynastic precautionary savings to wealth accumulation and intergenerational transfers, and (iii) assess the effect of two policy proposals that can affect parents’ incentives to engage in dynastic precautionary savings: universal basic income and guaranteed minimum income. Lastly, I explore the implications of strategic interactions between parents and children for parents’ precautionary and dynastic precautionary behavior.

This is a seriously cool paper. I can even relate to it on a personal level… With all the talk about increased uncertainty for the new generation, this is important work. It is also important to see what the implications are for mobility, because if only wealthy parents can give such a security blanket to their kids, a lot of untapped talent will remain unused. This is something we already worry about for access to education, and this paper shows that this is also important for the first years on the job market as well.

Quantifying the Welfare Gains from History Dependent Income Taxation

August 4, 2017

By Marek Kapicka

I quantify the welfare gains from introducing history dependent income tax in an incomplete markets framework where individuals face uninsurable random walk idiosyncratic shocks. I assume that the income tax paid is a function of a geometrical weighted average of past incomes, and solve for the optimal weights. I find that the optimal weights on past incomes decline geometrically at a rate equal to the discount rate. The welfare gains from history dependence are large, about 1.77 percent of consumption. I decompose the total effect into an efficiency effect that increases labor supply, and an insurance effect that reduces volatility of consumption and find that, quantitatively, the insurance effect dominates the efficiency effect. The optimal tax increases consumption insurance by trading higher tax progressivity with repect to past incomes for a reduced tax progressivity with respect to the current income.

Interesting result. It clearly makes sense that taxes should not only depend on income in the current snapshot in time. The paper shows that even a rigid formula on past taxes easily enhances welfare. Imagine if the formula were more flexible than a weighted average.

Velocity in the Long Run: Money and Structural Transformation

July 24, 2017

By Antonio Mele and Radek Stefanski

Monetary velocity declines as economies grow. We argue that this is due to the process of structural transformation – the shift of workers from agricultural to non-agricultural production associated with rising income. A calibrated, two-sector model of structural transformation with monetary and non-monetary trade accurately generates the long run monetary velocity of the US between 1869 and 2013 as well as the velocity of a panel of 92 countries between 1980 and 2010. Three lessons arise from our analysis: 1) Developments in agriculture, rather than non-agriculture, are key in driving monetary velocity; 2) Inflationary policies are disproportionately more costly in richer than in poorer countries; and 3) Nominal prices and inflation rates are not “always and everywhere a monetary phenomenon”: the composition of output influences money demand and hence the secular trends of price levels.

It is rather well-known that the velocity of money has dramatically declined since the last recession, and the reasons are rather well understood and are largely of temporary nature. This paper made me aware of a larger trend in the decline of velocity, which could explain that velocity should not be getting back to pre-recession levels. How this is explained in the paper, though, is not too convincing for a modern economy: the agricultural sector is non-monetary, and as its importance in the economy shrinks, money velocity declines. Agriculture has been small already for some time in developed economies, and a further decline is not going to noticeably matter, and the sector is largely monetized by now.

A note on automation, stagnation, and the implications of a robot tax

July 18, 2017

Emanuel Gasteiger and Klaus Prettner

We analyze the long-run growth effects of automation in the canonical overlapping generations framework. While automation implies constant returns to capital within this model class (even in the absence of technological progress), we show that it does not have the potential to lead to positive long-growth. The reason is that automation suppresses wages, which are the only source of investment because of the demographic structure of the overlapping generations model. This result stands in sharp contrast to the effects of automation in the representative agent setting, where positive long-run growth is feasible because agents can invest out of their wage income and out of their asset income. We also analyze the effects of a robot tax that has featured prominently in the policy debate on automation and show that it could raise the capital stock and per capita output at the steady state. However, the robot tax cannot induce a takeoff toward positive long-run growth.

That paper left me puzzling. I think a lot of the results hinge on the particular production function that has been applied here: infinite elasticity of substitution between robots and humans, unit elasticity of substitution between them and “traditional” capital. I do not think reality is that extreme.