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.