Addressing Household Indebtedness: Monetary, Fiscal or Macroprudential Policy?

January 22, 2015

By Sami Alpanda and Sarah Zubairy

In this paper, we build a dynamic stochastic general-equilibrium model with housing and household debt, and compare the effectiveness of monetary policy, housing-related fiscal policy, and macroprudential regulations in reducing household indebtedness. The model features long-term fixed-rate borrowing and lending across two types of households, and differentiates between the flow and the stock of household debt. We use Bayesian methods to estimate parameters related to model dynamics, while level parameters are calibrated to match key ratios in the U.S. data. We find that monetary tightening is able to reduce the stock of real mortgage debt, but leads to an increase in the household debt-to-income ratio. Among the policy tools we consider, tightening in mortgage interest deduction and regulatory loan-to-value (LTV) are the most effective and least costly in reducing household debt, followed by increasing property taxes and monetary tightening. Although mortgage interest deduction is a broader tool than regulatory LTV, and therefore potentially more costly in terms of output loss, it is effective in reducing overall mortgage debt, since its direct reach also extends to home equity loans.

It is important to understand what drives household indebtedness, especially excessive indebtedness. While this paper is using the right method to look at this, I think it is asking the wrong questions. If there is excessive indebtedness, there must be some optimal level, and this optimal level is not zero. Thus, it is misplaced to focus on reducing debt, maybe one needs to increase it, at least for some segments of the population. I am also not sure that one should worry about the consequences on output with this model as it can directly measure well-being. When we use output, it is because we have no better proxy. The paper is still very much worth reading, keeping in mind the questions it should be addressing. Once refocused, this is going to be a great paper.

Quantitative Easing in Joseph’s Egypt with Keynesian Producers

January 20, 2015

By Jeffrey Campbell

This paper considers monetary and fiscal policy when tangible assets can be accumulated after shocks that increase desired savings, like Joseph’s biblical prophecy of seven fat years followed by seven lean years. The model’s flexible-price allocation mimics Joseph’s saving to smooth consumption. With nominal rigidities, monetary policy that eliminates liquidity traps leaves the economy vulnerable to confidence recessions with low consumption and investment. Josephean Quantitative Easing, a fiscal policy that purchases either obligations collateralized by tangible assets or the assets themselves, eliminates both liquidity traps and confidence recessions by putting a floor under future consumption. This requires no commitment to a time-inconsistent plan.

I just could not resist posting this paper.

Saving Europe?: The Unpleasant Arithmetic of Fiscal Austerity in Integrated Economies

January 16, 2015

By Enrique Mendosa, Linda Tesar and Jing Zhang

What are the macroeconomic effects of tax adjustments in response to large public debt shocks in highly integrated economies? The answer from standard closed-economy models is deceptive, because they underestimate the elasticity of capital tax revenues and ignore cross-country spillovers of tax changes. Instead, we examine this issue using a two-country model that matches the observed elasticity of the capital tax base by introducing endogenous capacity utilization and a partial depreciation allowance. Tax hikes have adverse effects on macro aggregates and welfare, and trigger strong cross-country externalities. Quantitative analysis calibrated to European data shows that unilateral capital tax increases cannot restore fiscal solvency, because the dynamic Laffer curve peaks below the required revenue increase. Unilateral labor tax hikes can do it, but have negative output and welfare effects at home and raise welfare and output abroad. Large spillovers also imply that unilateral capital tax hikes are much less costly under autarky than under free trade. Allowing for one-shot Nash tax competition, the model predicts a “race to the bottom” in capital taxes and higher labor taxes. The cooperative equilibrium is preferable, but capital (labor) taxes are still lower (higher) than initially. Moreover, autarky can produce higher welfare than both Nash and Cooperative equilibria.

It is becoming increasingly difficult to macroeconomic analysis without including the international dimension, and nowhere is this more true that in Europe. As long as it does not have a substantial pan-European fiscal coordination (or even authority), member countries will play games. This paper shows they matter. It is great to introduce institutions that foster mobility of factors, but this will change the way you do domestic policy. Or you can shift the definition of domestic to mean European.

Optimal Fiscal Management of Commodity Price Shocks

January 14, 2015

By Pierre-Richard Agénor

A dynamic stochastic general equilibrium model is used to study the optimal fiscal response to commodity price shocks in a small open low-income country. The model accounts for imperfect access to world capital markets and a variety of externalities associated with public infrastructure, including utility benefits, a direct complementarity effect with private investment, and reduced distribution costs. However, public capital is also subject to congestion and absorption constraints, with the latter affecting the efficiency of infrastructure investment. The model is parameterized and used to examine the transmission process of a temporary resource price shock under a benchmark case (cash transfers) and alternative fiscal rules, involving either higher public spending or accumulation in a sovereign fund. The optimal allocation rule between spending today and asset accumulation is determined so as to minimize a social loss function defined in terms of the volatility, relative to the benchmark case, of private consumption and either the nonresource primary fiscal balance or a more general index of macroeconomic stability, which accounts for the volatility of the real exchange rate. Sensitivity analysis is conducted with respect to various structural parameters and model specification.

The topic of this paper must be the most burning one right now, with various oil-exporting developing economies going through a very hard times following the spectacular drop in oil prices. The paper looks at the angle of a windfall in oil revenues, but the model is symmetric and one can thus draw opposite conclusions for the opposite shock. But is this right? This maybe a poster case for when log-linearization around a steady-state does not apply. The shocks are too big to be only small(ish) deviations from the steady-state that are OK with linearization, and it seems to me that there is a definitive non-linearity once you consider that a country may have to default on sovereign debt. Of course, looking at this kind of situation may not be what the author had in mind when drawing the model and its solution method.

Constrained Efficiency with Search and Information Frictions

December 31, 2014

Mohammad Davoodalhosseini

I characterize the constrained efficient (or planner’s) allocation in a directed (competitive) search model with private information. There are sellers with private information on one side of the market and homogeneous buyers on the other side. They match bilaterally in different submarkets and trade. In each submarket, there are search frictions. In the market economy, homogeneous buyers enter different submarkets (i.e., post different contracts) and sellers with private information direct their search toward their preferred submarket. I define a planner whose objective is to maximize social welfare subject to the information and matching frictions of the environment. The planner can impose taxes and subsidies on agents that vary across submarkets while being subject to an overall budget-balance condition. I show that the planner generally achieves strictly higher welfare than the market economy. I also derive conditions under which the planner achieves the complete information allocation. I present examples in the context of financial and labor markets, explicitly solve for the efficient tax and transfer schemes and compare the planner’s allocation with the equilibrium allocation.

This a huge paper. Literally (64 pages), it indeed covers a lot of ground, but also in terms of its message. The abstract, while very precise, does not highlight the potential impact of this paper. We have learned from the Welfare Theorems that a planner can replicate a decentralized economy under perfect conditions. As socialist planned economies have demonstrated, these perfect conditions do not exist, one main reason being that the planner has less information than market participants. Here we have an economy where some market participants have more information than others and the planner has as much information as those that have the least of it. Yet, the planner is capable to improve on the decentralized outcome. It is not simple, as the planner needs to use subsidies and taxes, and to open and close markets. But it is possible.

Financial frictions, the housing market, and unemployment

December 29, 2014

By William Branch, Nicolas Petrosky-Nadeau and Guillaume Rocheteau

We develop a two-sector search-matching model of the labor market with imperfect mobility of workers, augmented to incorporate a housing market and a frictional goods market. Homeowners use home equity as collateral to finance idiosyncratic consumption opportunities. A financial innovation that raises the acceptability of homes as collateral raises house prices and reduces unemployment. It also triggers a reallocation of workers, with the direction of the change depending on firms’ market power in the goods market. A calibrated version of the model under adaptive learning can account for house prices, sectoral labor flows, and unemployment rate changes over 1996-2010.

A great paper that captures some of the essential frictions in the macroeconomy. A great next step would be to bring in some geography. A major friction, I believe, is that when a recession hits a region, the unemployed cannot move to greener pastures because their house cannot be sold. This cannot be captured in the model above because everyone lives in the same economy. The improved model would also be great to capture the cost of this moving friction, which should be taken into account when thinking about homeownership subsidies.

International Trade and Intertemporal Substitution

December 22, 2014

By Fernando Leibovici and Michael Waugh

This paper studies the dynamics of international trade flows at business cycle frequencies. We show that introducing dynamic considerations into an otherwise standard model of trade can account for several puzzling features of trade flows at business cycle frequencies. Our insight is that because international trade is time-intensive, variation in the rate at which agents are willing to substitute across time affects how trade volumes respond to changes in output and prices. We formalize this idea and calibrate our model to match key features of U.S. data. We find that, in contrast to standard static models of international trade, our model is quantitatively consistent with salient features of U.S. cyclical import fluctuations. We also find that our model accounts for two-thirds of the peak-to-trough decline in imports during the 2008-2009 recession.

There were lots of exciting papers to choose from in this week’s NEP-DGE report. I chose this one because it shows that international trade theory is finally awakening from its slumber to realize that dynamics and expectations matter. I think that is pretty big in itself.


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