Embargoeduntilpresentationtimeof8:00a.m.

MountainDaylightTime,Saturday,September1,2012

Redistributive Monetary Policy1

Markus K. Brunnermeier and Yuliy Sannikov
PrincetonUniversity August,2012

Abstract
Liquidityanddeflationaryspiralsselfgenerateendogenousriskandredistributewealth.Monetary policycanmitigatetheseeffectsandhelprebalancewealthafteranadverseshock,therebyreducing endogenousrisk,stabilizingtheeconomy,andstimulatinggrowth.Theredistributivechanneldiffers fromtheclassicKeynesianinterestratechannelinmodelswithpricestickiness.Centralbanksassume andredistributetailriskwhenpurchasingassetsorrelaxingtheircollateralrequirements.Monetary policy(rules)canbeseenasasocialinsuranceschemeforaneconomybesetbyfinancialfrictions.As withanyinsurance,itcarriesthecostofmoralhazard.Redistributivemonetarypolicyshouldbestrictly limitedtoundoingtheredistributioncausedbytheamplificationeffectsandbymoralhazard considerations.

Thispaperwaspreparedforthe2012JacksonHoleSymposiumhostedbytheFederalReserveBankofKansas City,August31toSeptember1,2012.WearegratefultoTobiasAdrian,EvanFriedman,MasazumiHattori,Nobu Kiyotaki,JeanPierreLandau,HyunShin,LarsSvensson,MarkWatson,andespeciallytoDelwinOlivanforhelpful suggestions.

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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012

1. Introduction
Shorttermdebtfinancingplayedanimportantroleintherunuptothefinancialcrisis,asincreasesin leveragehelpedboostgrowthbutalsomadetheeconomymoresusceptibletoasharpdownturn.Since therecession,privateagentshavereducedtheirdebtlevelwhilemanypublicgovernmentshave increasedborrowing.Thisdeleveragingprocessappearstobeholdingbacktherecovery,andthe Japaneseexperiencesuggeststhatsuchdeleveragingcancontinueoveranextendedperiod. Economicactivitydependsonwealthdistributionandtheriskbearingcapacityofvarioussectorsand actorsintheeconomy.Inaworldwithexcessivedebtfinancing,amplificationofadverseshockscan triggerlargewealthredistributionsacrossandwithinsectorsthatstiflegrowth.InJapan,thenon financialbusinesssectorsufferedmostfromliquidityanddeflationspirals,whilecurrently,intheUnited States,thehouseholdsectorlargelybearsthecostsofthesespirals. Thispaperarguesthatmonetarypolicycanmitigatetheredistributiveeffectsoftheadverse amplificationmechanismsandhelprebalancewealthacrossvarioussectorsandhouseholds.The wealthredistributivemonetarytransmissionchannelworksthroughchangesinassetpricesand profitability.Thekeyinsightisthatsinceeconomicagentsdifferintheirassetholdings,monetarypolicy redistributeswealth.Appropriatemonetarypolicycanmitigatedebtoverhangdistortions.Thisstabilizes theeconomy,reducesendogenousrisk,andcanspurgrowth,raisingtheoverallwealthlevelinthe economy.Forspecificscenarios,monetarypolicycanevenleadtoexpostParetoimprovements, makingallagentsintheeconomybetteroff. ThiswealthredistributionchanneldiffersfromthetraditionalKeynesianinterestratechannel.Inthose models,thekeyfrictionisduetopricestickiness,notfinancialfrictions.Assuch,loweringthenominal interestratelowerstherealinterestrate.Alowerrealinterestratestimulatesaggregateconsumption andinvestmentastherepresentativeagentbringsconsumptionforward.InmostNewKeynesian models,theinterestratesaresetbyarule,e.g.,theTaylorrule,andmoneyservesonlyasaunitof account.Thezerolowerboundofthenominalinterestratelimitstheeffectivenessofconventional monetarypolicy. Ingeneral,conventionalmonetarypolicyfocusesprimarilyontheshortendoftheyieldcurve. Expectationsaboutfuturepolicyindirectlyaffectthelongendoftheyieldcurve.Unconventional monetarypolicydirectlytargetsthelongendoftheyieldcurveandpricesofspecificassets.Allthese measurescanredistributewealthacrossandwithinsectors.Forexample,wefindthatadeclineofthe 10yearinterestratethatwidensthe25to10yeartermspreadhurtslifeinsurancecompaniesand pensionfunds. Centralbanksalsoassumetailrisk.Theytransferriskawayfromtheprivatesectors.Moreprecisely, centralbanksredistributetailrisktomanynominalclaimholdersacrosstheeconomy.Theredistribution 2

Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 ofriskisawealthredistributioninthefuturecontingentonspecificfuture(tail)events.Forexample, purchasesofriskyassetsredistributeriskoftheultimatepayoffoftheseassetstoallnominalclaim holdersintheeconomy.Centralbanksthatrelaxcollateralrequirementsforlendingprogramsinsure againstthetaileventinwhichtheborrowerandthecollateralfailtocovertheborrowedamount. Importantly,theredistributionofriskisnotazerosumgame.Mostoftheriskintheeconomyis endogenousi.e.,selfgeneratedbythesystem.Hence,appropriatemonetarypolicycanreducethe overallriskintheeconomy. Moregenerally,monetarypolicy(rules)canbeseenasastabilizingimplicitsocialinsurancescheme acrossagentsandsectorsforeconomiesbesetbyfinancialfrictions.Essentially,monetarypolicy (partially)completesmissingmarkets.Theefficiencygainsarelargestwhenexogenousriskissmalland selfgeneratedendogenousriskislarge.Thelatteristhecasewhentheproductivityorvaluationgap betweennaturalholdersandsecondbestholdersofassetsislarge.Withalargegap,firesalesfromthe naturalholdersofassetstoothersleadtolargepricemovementsamplifiedbyliquidityanddeflationary spirals.Formonetarypolicytoworkasasocialinsurancescheme,thecentralbankhastofollowand clearlycommunicateanexantewellspecifiedpolicyrule. Aswithanyinsurancescheme,monetarypolicycomesatthecostofmoralhazard.Tokeepmoral hazardcostsundercontrol,thedesignoftheredistributionschemeiscrucial.Forexample,if recapitalizationeffectsofmonetarypolicyareproportionaltothebanksnetworthi.e.,thepolicy helpsstronginstitutionsmorethanweakonesthencompetitioninnormaltimeswithinthesector keepsmoralhazardincheck.Ofcourse,supportingstrongerhealthybanksintimesofcrisisisexpost morecostly.Exante,however,thiscommitmentmakesmonetarypolicylesspronetomoralhazard comparedtomoretargetedpolicyinstrumentsthatsubsidizetheweakinstitutions. Generally,theintentofamonetarypolicyruleistoaffecttheeconomicagentsbeliefsandbehaviorin ordertosteertheeconomytowardthesociallydesirableobjective.Asymmetricinformationproblems, suchasmoralhazard,limittheeffectivenessofsuchrulesandconstrainthesetofimplementablerules. Inotherwords,systemicfinancialinstitutionscanunderminesomedesirablerulesandmayevenbeable toforcethecentralbanktoabandonitsrulebook.Redistributivemonetarypolicyshouldbestrictly limitedtoundoingtheredistributioncausedbytheamplificationeffectsandbymoralhazard considerations. Untilrecently,thepredominantviewwasthatthethreeobjectivesofpricestability,financialstability, andfiscalgovernmentdebtsustainabilitycanbetreatedindependentlyfromeachotherandassigned separatelytomonetary,regulatory,andfiscalauthorities,respectively.Thisviewfailstoseethatthe centralbankcanbecorneredbyfinancialinstitutionsandfiscalauthorities.Fiscalauthoritieswilltryto forcethecentralbanktomonetizegovernmentdebtinordertoavoidpoliticallyunpopularausterity measures.Incrisissituations,centralbanksmightfacetheunpleasantchoicebetweenfiscaldominance withassociatedinflationorgovernmentdebtdefault.Thepurepossibilityofgovernmentdebtdefault leadstoadiabolicloopbetweensovereignriskandbankingrisk.Assovereigndefaultprobabilityrises, bankssufferlossesandcutbacktheirlending.Thisslowsdownthegrowthoftherealeconomyaswell asthetaxrevenueforthesovereign.Atthesametime,abailoutofbanksmightbecomemorelikely. 3

Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Overall,intimesofcrisis,opposingdeflationaryandinflationaryforcesarestrongandbalancingthem becomeschallenging.Theeconomyisveryunforgivingtoevensmallmistakes.Itcaneasilydriftofftoa deflationaryorinflationarytrajectory. Topreempttheseforcesfromtakingover,forwardlookingmonetaryandmacroprudentialpolicyhasto incorporateearlywarningsignalsaboutthepotentialbuildupofsystemicrisk.Lowvolatility environmentsandfinancialinnovationsareconducivetosuchabuildup.Simplemeasuresofdebtto GDPratioandleverage,ormoresophisticatedliquiditymismatchmeasuresacrosssectors,are indicatorsofvulnerability. Thenextsectionofthispaperpresentssomesummarystatisticsandoutlinessomesimpleempirical observations.Sincedataforcounterfactualscenariosaresparse,themainpartofthepaperrelies heavilyontheoreticalreasoning.Variouspolicymeasuresareanalyzedthroughthelensoftworecent theoreticalpapersbyBrunnermeierandSannikov(2011,2012),referredtoasBruSanhereafter.Both thesepapersbuildonearlierworkonfinancialfrictionsinthemacroeconomybyBernankeandGertler (1989),KiyotakiandMoore(1997,2011),andBernanke,Gertler,andGilchrist(1999).Foradetailed surveyoftheexistingliterature,wereferreaderstoBrunnermeier,Eisenbach,andSannikov(2012).

2. A Preliminary Look at the Data

Westartwithsomestylizedobservationsbeforeconceptualizingtheredistributiveeffectsofvarious amplificationmechanismsandstudyingpolicyresponsestothem.Followingearlierworkbyeconomists likeArthurBurnsandWesleyMitchell,CooleyandPrescott(1995)characterizestylizedfactsofbusiness cycleswithoutmakingmuch,ifany,referencetofinancialvariablesordebtlevels. Becausefinancialfrictionslimittheflowoffunds,thedistributionofwealthandagentsriskbearing capacityareofhugerelevancefortheefficientallocationofeconomicresources. Highleverageexposeseconomicagentstosuddenshiftsinwealth.Therefore,wefirstreportdebtto GDPratiosacrossvarioussectors.DebttoGDPpermitsabettercrosssectionalcomparisonthanwould debttoequity.Amongflowvariableswefocusondebtserviceburdenmeasures.Peoplewithhighand variabledebtserviceburdenaremorevulnerabletocashfloworliquidityshortages.However,looking atthesemeasuresbasedonexistingdatagivesusonlyaroughguideline.Amoreadvancedapproach wouldinvolvelookingatrisktopographyandliquiditymismatchacrossvarioussectorstocapturethe endogenousresponsesandfeedbackloops.2 Asasecondstep,wewouldlikesomeideaofhowmonetarypolicyhelpsmitigateredistributional effectsduringtherunuptoandinfinancialrecessions.Thisis,ofcourse,anevenmorechallengingtask 2 Forexample,Brunnermeier,Gorton,andKrishnamurthy(2012,13)proposetoelicitfromeachfinancialfirmits1)
valueexposureand2)liquidityexposuretochangesinkeyriskfactorsandscenarios.Thisinformationcanbefed intoageneralequilibriumframeworktodeterminetheimpactofkeyrisksonassetprices.

Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 becausepolicyresponsesareendogenous.Wedonotobservewealthshiftsthatwouldhaveoccurredin acounterfactualworldwithoutpolicyreaction. Thefirsttaskistoselecttherightgroupingintosectors.Indeed,thewholeanalysisdependsonthe classificationandclusteringofvariouseconomicagents.Theoptimalclusteringdependsonthe economicquestionandtheavailabilityofdata.Tobegin,wefollowtheclassicsectoranalysis,which dividestheeconomyintoahouseholdsector,nonfinancialbusinesssector,financialsector,and governmentsector.Thisgroupingintosuchlargesectorsremovesasignificantquantityofintrasector debtthroughnettingofoffsettingloans.Ofcourse,aggregatetotaldebtinaclosedeconomyiszero.To furtherouranalysis,wetakeacloserlookatthefinancialsectoranddisaggregateitintovarious subsectors.Thissectorisofparticularinterestasitliesatthecenterofmanybalancesheetrecessions.

2.1 Debt and Leverage

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Figure1:DebttoGDPratiosforseveralsectorsovertimeintheU.S.(PanelA)andJapan(PanelB).NBER recessionsarerepresentedasshadedcolumns. Figure1depictsthedebttoGDPratiosforthekeysectors.PanelAshowsthedebtratiosfortheUnited States,andPanelBisthecorrespondinggraphforJapan.NBERdesignatedrecessionsarerepresented asshadedlines. PanelAclearlydocumentsthattheoveralldebtlevelintheU.S.economyhasincreasedsignificantly overtime.Thefirstobservationwecandrawfromthedataisthatnotallrecessionsarethesame.From 1960to1985,thedebttoGDPratiosofthemainsectorschangedverylittle.Forexample,therecession in1980wasnotprecededbyanexpansionofdebtandwasinducedbytheFederalReservestightening ofmonetarypolicytoconquerinflation.

Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Intherecessionoftheearly1990s,afterthesavingsandloan(S&L)crisis,thenonfinancialbusiness sectorreduceditsdebtlevel.Itisdifficulttodrawmoredetailedconclusionsfromthenonfinancial businessdebttoGDPtimeseries(bottomarea).Indeed,thetemporaryreductionofnonfinancial businessdebtduringtheGreatRecessionisconsistentwiththeempiricalfindingthatthissector significantlyexpandeditscashholdingsevenbeforethecrisis,asdocumented,forexample,inBates, Kahle,andStulz(2009). ThehouseholddebttoGDPratiosteadilyincreasesfromthemid1980sonwards,despitethebursting oftheInternetbubblein2000andtheassociatedrecession.ThesharpdropfollowingtheGreat Recessionisstriking.Householdssignificantlyreducedtheirspendingandincreasedtheirsavingsin ordertorepairtheirbalancesheets.Apartofthedeclinecanbeattributedtodefaultsonmortgage debt,whichinducedlossesinthebankingsector.Financialsectordebtalsorosesteadily,althoughit recordedasmalldeclineduringtherecessionoftheearly1990s.Governmentdebtdeclinedduringthe ClintonyearsandsignificantlyincreasedduringtheGreatRecessionessentiallyreplacingdeclining householddebt. Observation1:Notallrecessionsarethesame.Somerecessionsareprecededbyarunupindebtand thenaccompaniedbyasubsequentdecline,butothersarenot. PanelBdepictsthesamegraphforJapan.PriortoJapanslostdecades,assetpriceappreciationwas evenhigherinJapanthanintheUnitedStatesinthe2000s.PanelB,however,clearlyshowsthatin Japanthenonfinancialbusinesssector,nothouseholds,builtuplargeamountsofdebtinthe1980s. From1990onwards,thenonfinancialbusinessdebttoGDPratiohasremainedroughlyconstantasthis sectorsbalancesheetshavebeenunderrepair.Fromlate1996onwards,thisdeleveragingaccelerated andthenonfinancialbusinessdebttoGDPratiodeclinedforseveralyears. Interestingly,1997correspondstothepeakinnominalGDP,andthatyearcanbeseenasthetransition fromadeeprecessiontoasustainedstructuralslump.In1996,8.0trillionyenofassetsweretiedupin bankruptcyproceedings.By1997,thisnumberhadjumpedto14trillionyen(seeHamada,Kashyap,and Weinstein(2011)).Incontrast,thehouseholdsectorsdebtlevelexperiencedonlyamarginalincrease overtheseyears,withasmallslowdowninthefirstfewyearsof1990s.The1997watermarkrecessionis almostundetectableinthetimeseriesofhouseholddebt. King(1994)studiedrecessionsinearly1990acrossmanycountries.Hedocumentsthatcountrieswith thelargestincreaseinprivatedebtfrom1984to1988experiencedthedeepestshortfallofgrowthin theperiodfrom1989to1992.ThisevidenceandthecontrastbetweenPanelsAandBleadtothe secondobservation. Observation2:Notallbalancesheetrecessionsarethesame;differentsectorscanbeinvolved. AnotherdifferencebetweentheJapaneseandU.S.crisesistheextenttowhichforeigncreditflowwas involved.Hence,methodsforpreventingfinancialrecessionsmightalsodiffer,dependingonwhich sectorssufferfromdebtoverhangproblems.

Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Finally,intheUnitedStatesaswellinJapan,financialrecessionsledtohighergovernmentdebt. Observation3:Governmentdebtinacrisisoftenincreasesbymorethanthecombineddecreasesin householdandnonfinancialbusinessdebt. Figure1groupsallhouseholdstogether.However,householdsdebtexposureandrealestateholdings varyalotwiththeirageandskilllevel.Consequently,interestratesandinflationcanleadtolarge wealthshiftswithinthehouseholdsectoracrossdifferentagecohorts. MianandSufi(2009)usemicroeconomichouseholddataacrossU.S.countiestoshowthattherisein householdleverageduringthecreditboomwasastrongpredictorofrecessionseverityfrom2007to 2009.Countiesthatexperiencedthelargestincreaseinhouseholddebtbeforetherecession subsequentlysawlargerincreasesinunemploymentandlargerdecreasesinresidentialinvestmentand durableconsumption. Theredistributionaryeffectsofinflationhavelongbeenrecognized(see,e.g.,Keynes(1923)).Itisuseful todrawadistinctionbetweenanticipatedandunanticipatedinflation,asemphasizedinKesseland Alchian(1962).ManystudiesfocusontheU.S.GreenbackerafollowingtheU.S.CivilWar(see,e.g., FriedmanandSchwartz(1963))orWeimarinflation(see,e.g.,BrescianiTurroni(1937)).Morerecently, DoepkeandSchneider(2006)provideadetailedandcomprehensivestudyofredistributionaleffectsof inflationacrossdifferentagegroupswithintheUnitedSates.Coibionetal.(2012)studytheimpactof monetarypolicydecisionsonconsumptionandincomeinequality.Theyarguethatcontractionary monetarypolicyincreaseslaborincomeinequality. Sofar,ourfocushasbeenprimarilyondebt,but,ofcourse,onepersonsdebtisanothersfinancial asset.3Nonfinancialclaimsonrealprojects,property,andphysicalcapitaldifferinthattheyarenot relatedtoliabilities.Thepresentrealvalueofmostoftheseassetsdependsoncurrentandfuture interestandinflationrates.Inflationsurprisescanerodethevalueoflongdatednominalclaims.The differencebetweenassetsandliabilities,i.e.,networthorwealth,ofasectorshiftsaroundacrosstime. Ultimately,allclaimsareheldbyhouseholds.Forexample,firmswealth(equity)isownedbyits shareholders.Whendefiningwealthshares,itisimportanttoassignwealthtothosesectorsthatarein controlofresources.Inthissetting,itisclearthatcorporateexecutives,nothouseholds,possessthe decisionmakingcapitalbackedbythisequity.Whenviewedfromthisperspective,itbecomesapparent thatflowsareimportantaswell.

2.2 Debt Service Burden

Sofar,wehavefocusedonstockvariableswhosevaluemightappreciateordepreciateaseventsunfold. Toaddressliquidity,wemustalsoconsiderflowvariables,suchascashflows.Here,wefocusondebt serviceburdens.

Indeed,whencalculatingthenetliabilitiesofthebankingsector,wesimplyaddedupthefixedincomeclaimsby theothersectors(includingtheforeignsector).
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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Forthehouseholdsector,theFederalReserveprovidesthehouseholddebtserviceratio(DSR),whichis anestimateoftheratioofdebtpaymentstodisposablepersonalincome.Debtpaymentsconsistofthe estimatedrequiredpaymentsonoutstandingmortgageandconsumerdebt.Thefinancialobligations ratio(FOR)simplyaddsleasepayments,rentalpayments,homeownersinsurance,andpropertytaxes. Theseratioscanbehighfortworeasons:high(real)interestratesorhighdebtlevels.Alowinterest rateenvironmentisassociatedwithhighhousepricesandthushighdebtlevels.Thisexplainswhythe financialobligationsratioforhouseholdsinFigure2isrelativelystable.

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Figure2:Householdfinancialobligationsratiocomparedtorelevantinterestrates.Toptobottom (leftaxis):Householdfinancialobligationsratiocontrolledforpricetorent;(noaxis):pricetorentratio; (rightaxis):30yearmortgagerate;threemonthTreasurybillrate;Michiganinflationexpectations. Observation4:Forthehouseholdsector,adeclineinthemortgageratehastwoeffects.First,as householdscanrefinancemortgagesatlowerrates,thedebtserviceratiodeclines.Second,lower interestratesleadtohigherhouseprices,andhouseholdstakeoutlargermortgagestofinancetheir houses. Inotherwords,thedebtserviceratioshouldbeproportionaltotherealinterestratetimesthedebt level(orhouseprices).Toseparatethedirectfromtheindirecteffect,weregressthelogofthedebt serviceratiotothelogoftherealinterestrateplusthelogofthepricerentratio.WeusetheFHFA HomePriceIndex.Theregressionyieldsthefollowingcoefficients: LogFORatio LogReal30yMtg.Rate Coefficient 0.0227 * StandardError 0.0101 Rsquared 0.6045 LogPricetoRent 0.3697 *** 0.0603 Constant 1.7486 *** 0.0296

Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Table1:Logfinancialobligationratioregressedonlogreal30yearmortgagerateandthelogpriceto rentratio.*refersto5%,**to1%,***to.1%statisticalsignificance. ThelowerpartofFigure2depictsthereal30yearmortgagerateandtherealthreemonthTreasury rate.Togetrealrates,wesimplysubtracttheexpectedinflationrateasmeasuredbytheMichigan survey.Thecoloredareabetweenbothratesreflectsthespreadbetweenthem.Thechartconfirmsthe empiricalfindingthatlowinterestratesareassociatedwithhighhousepricetorentratiosandtheFOR controlledforthehousepriceeffectpositivelycommoveswiththe30yearmortgagerate. Figure2showsthedebtserviceburdenforhouseholds.Twoaspectsareworthemphasizing.First,the debtserviceburdenrisesmoderatelyfrom1995onwards.Relativetotheoverallincreaseofhousehold debt,theincreaseindebtserviceburdenhasbeenmodestbecauseofthedeclineininterestrates. Morepronouncedisthesharpdropofthedebtserviceburdenfrom2008onwards.Thissharpdeclineis duetothedeclineindebtandthedropininterestratesthateasedthefinancialconstraintson households. Forthenonfinancialbusinesssector,weconductasimilarexercise.Weconsidertheinterestexpenseas afractionofearningsbeforeinterest,taxes,depreciation,andamortization(EBITDA).Thedataarefrom CompuStat,takingtheratioacrosstheaggregatesectorexcludingfinancialfirms,insurancecompanies, andrealestate(SICCodes60xx,61xx,62xx,63xx,64xx,65xx). Observation5:Debtserviceburdenforthenonfinancialcorporatesectorispositivelyrelatedtothe interestrateandthespreadbetweentheMoodyscorporateBAAindexandthethreemonthTreasury interestrate. FortheregressionofthedebtserviceburdenontherealthreemonthTbillrateandtherealcorporate BAAcreditspread,thepositivecoefficientonthespreadishighlysignificantata0.11%level. InteresttoEBITDA Corporate3mTsy Real3mTsy Constant Coefficient 1.2067 ** 1.4499 *** 0.1169 *** StandardError 0.3597 0.2538 0.0183 Rsquared 0.5298 Table2:NonfinancialbusinessinteresttoEBITDAratioregressedontheCorporateBAAindexspread overthethreemonthTreasuryrate.

2.3 A Closer Look at the Financial Sector

Apartfromitsroleinmanybalancesheetrecessions,thereareseveralotherreasonstosplitupthe financialsector.First,thefundingflowwithinthefinancialsectorislarge.Bysimplyaggregatingall financialfirmsandnettingoutexposures,wemisssystemicriskandamplificationmechanismsthatarise withinthefinancialsector.Second,riskexposuresofdifferentgroupsinthefinancialindustrydiffer significantly.Forexample,commercialbanksareactiveinmaturitytransformation,whilelifeinsurance andpensionfundshavecomplementaryexposuretoyieldcurvechanges.Third,differentaccounting rulesmakeitdifficulttocomparedifferentfinancialindustries.Whilemostassetsofinvestmentbanks

Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 aremarkedtomarket,forcommercialbanksonlythesmallertradingbook(andnotthebankingbook) followsmarketprices.Differencesinaccountingrulesaffectnotonlydata,butalsofirmsbehavior. Wegroupfinancialfirmsintocommercialbanks,bankholdingcompaniestogetherwithinvestment banks,shadowbankinginstitutions,governmentagencies,insurancecompanies,andpensionfunds. Traditionalcommercialbanksdebtconsistsprimarilyofdemanddeposits,CDs,interbankmarket funding,andfundingfromtheirbankholdingcompanies(BHCs).Bankholdingcompaniesissuelong termbonds,mediumtermnotes,and(financial)commercialpaper.SomeBHCsarealsoactiveinthe investmentbankingbusiness.AfterLehmansfailureinSeptember2008,alllargeinvestmentbanks becameBHCs.Hence,wegroupBHCswithinvestmentbanksthathavebrokerdealerbusinesses. BHCsandinvestmentbankshavenetrepoliabilitiestothenonfinancialbusinesssectorandthe householdsector.Corporationsusetherepomarketlikeacheckingaccounttoholdshorttermfunds. Theyalsoinvestalongwithhouseholdsinmoneymarketfundsandotherbondfunds. Moneymarketfundsarepartofthe(lessregulated)shadowbankingsystem.Moneymarketfunds investinvariousothershadowbankinginstitutionsandstructuredvehicles,suchassecuritized mortgagepools,autoloans,andcreditcardreceivables.Whilemanyobligations(includingrepos)net outwithintheshadowbankingsector,shadowbankinginstitutionsalsoholdlongtermdebtofBHCs andinvestmentbanks.PriortotheGreatRecession,BHCsobtainedcheapsecuredfundingsincethey couldrehypothecatetheircustomerscollateralatfavorablehaircuts.Theirsecuritieslendingactivityis partofthisactivity. GovernmentagencieslikeFreddieMacandFannieMaewerelargeplayersinsecuritizationoften simplybypooling(qualified)mortgagesandissuingagencybonds.TheU.S.governmentinitially implicitlyguaranteedand,sinceJuly2008,hasexplicitlyguaranteedtheseagencybonds. Welookseparatelyatinsurancecompaniesandpensionfundssincethematuritystructureoftheir assetsandliabilitiesisdifferentfromthatoftraditionalandshadowbanks.Insurancecompaniesand pensionfundshavelongdatedliabilities.Hence,changesintheyieldcurveaffectthemverydifferently fromtherestofthefinancialsector. Overall,itisdifficulttofindreliablemeasuresofthesesectorsdebtobligations.Thisisespeciallytrue fortheshadowbankingsector.Manyentities(suchashedgefunds)donotreporttheirholdingsand liabilities.Anotherproblemisthedoublecountingofdebtwithinasectorastheintermediationchain grows.ThisdoublecountingexplainsalargepartofthegrowthoffinancialinstitutionsdebtinFigure1. ForeignbanksthatareactiveintheU.S.alsocomplicatethepicture.

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Figure3:DebttoGDPratioofcommercialbanks,shadowbanks,governmentsponsoredenterprises, andbankholdingcompaniesincludinginvestmentbanks.NBERrecessionsarerepresentedasshaded columns. Figure3illustratesthedebtlevelsofvariouscomponentsofthefinancialsector.Comparedtotheresult showninFigure1,thedebttoGDPratioofthetotalfinancialsectorisnowhigher,sincedebt obligationswithinthelistedfourfinancialsectorgroupsarenotnettedoutinFigure3. Thegeneraltrendisasteadyandfastriseinshadowbanking,partlyattheexpenseofthetraditional bankingsystemfromthe1980sonwards.Duringthatperiod,thefollowingeventsoccurred:1)BaselI createdincentivesforsecuritization,and2)interestrateregulationfavoredmoneymarketfunds.Atthe sametime,ITinnovationsmadecollateralmanagementforrepomarketseasier. DuringtheS&Lcrisisinthe1980sandearly1990s,theburgeoningshadowbankingsectoronlypartly compensatedfortheslowdownintraditionalbankingactivity.However,financialsectorliabilitiesgrew atonlyamoderatepacepriortotheS&Lcrisis. Thisresultisinstarkcontrasttothebeginningofthecurrentfinancialcrisis,whereweobservedasharp dropinshadowbankingactivityinthesecondhalfof2007.TheinitialdropoccurredasABSissuance andtheABCPmarketfrozeup.Interestingly,thisdropwasmorethanoffsetbyanexpansioninactivity bythegovernmentsponsoredenterprises(GSEs)andFederalHomeLoanBank.AcloserlookatFigure3 alsohighlightstherolethatGSEsplayedintheearlypartofthecrisis.InJuly2008,thedebtof governmentagenciesbecameexplicitgovernmentdebtanditseemsthattheGSEslosttheirmoderating 11

Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 role.TherealcollapseoftheshadowbankingsystemfollowedthedemiseofLehman.Atthatpoint, investorsfledtoFDICinsureddemanddeposits,leadingtoanincreaseintheliabilitiesoftraditional banksatthattime.Foramoredetaileddescriptionoftheseevents,seeBrunnermeier(2009). Interestmovementscanaffectthevalueofassetsandliabilitiesoffinancialinstitutionsandalsoaffect futureearnings.Differentpartsofthefinancialindustryaresensitivetodifferentpartsoftheyield curve.Hence,nonconventionalmonetarypolicythattriestotargetthetermspreaddirectlyhas differentredistributionalconsequencesthanasimplereductionintheshortterminterestrate. ForcommercialbanksandBHCs,datafromCallReportsallowustosplitnetincomeintonetinterestand netnoninterestincome.Accountingrulesplayanimportantroleintheregressionspecification.Ifassets aremarkedtomarket,thenaninterestratecutthatsteepenstheslopeoftheyieldcurveleadstoan immediatecapitalgainreportedasanincreaseinnoninterestincome.Ontheotherhand,iftheposition isnotmarkedtomarket,anincreaseinaninstitutionsprofitabilitythroughhighernetinterestmargins showsuponlywithalaginthenetinterestincomelineitem. Adetailedstudyoftheeffectsofinterestratechangesonbankstockreturnsandincomecanbefound inEnglish,VandenHeuvel,andZakrajsek(2012).Here,wereportasectionofTable8fromtheirpanel regressionresults. NetInterestIncome NoninterestIncome NetIncome 3mTsy 0.088 *** 0.015 0.051 *** (StdError) 0.014 0.011 0.010 10y3mTsy 0.071 *** 0.005 0.037 *** (StdError) 0.011 0.008 0.008 Rsquared 0.690 0.321 0.258 Table3:Thistablereportsthreeincometoassetratiosregressedonlevelandslopeoftheyieldcurve andvariousothercontrols.ThetableisanexcerptofTable8inEnglishetal.(2012). Intheirstudy,Englishetal.considerthreeincomemeasuresnormalizedbyassetsandregressthemon maturitygap,otherassets,otherliabilities,savingsdeposits,demanddeposits,loans,andbanksizeall interactedwithlevelandslope;theregressionsalsoincludelevelandslopeasindependentregressors andfourlagsofincome. Thefirstrowofregressioncoefficientsshowsthatanupwardparallelshiftoftheyieldcurveis associatedwithhighernetinterestandnetincomeoverassets.Thereareatleasttworeasonsforthis result.First,astheinterestrateincreasesthevalueofassetsdropsfasterthantheincome.Indeed,the authorsshowthatchangeinlogassetsissignificantlynegativelyrelatedtopositiveshiftsinlevelofthe yieldcurve.Second,thisresultcouldbesimplydrivenbythefactthattheleveloftheyieldcurveishigh wheneconomicgrowthishigh.Thatis,athirdomittedfactorcouldbedrivingtheseresultswithoutany directcausallinkbetweentheleveloftheyieldcurveandtheprofitabilityofbanks. Moreinterestingforourpurposesisthecoefficientonthetermspreadbetweenthe10yearTreasury bondandthethreemonthTreasurybillrate.Banksaretypicallyactiveinmaturitytransformation,and 12

Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 theirnetinterestincomeandnetincomerisewiththetermspread.Noninterestincomeshowsno significantchange. Tocontrolfortheendogeneityoftheseinterestratechanges,Englishetal.lookatsurpriseinterestrate movementsrelativetothepredictionsfromthefedfundsfuturesmarket.Bankstockpricesfall followinganunanticipatedriseintheleveloftheyieldcurve.Theyalsofall,however,withan unanticipatedsteepeningoftheyieldcurve. Ontheotherhand,Begenau,Piazzesi,andSchneider(2012)findthatthebigfourBHCsbenefitfrom interestratecuts.Thispaperassumesatwoyearswaprateasasinglefactor,sothatallrisks,even defaultrisk,canbereplicatedwithacombinationofalongmaturityrisklesspublicbondandcash. Withintheirframework,theyfindthatbanksaregenerallyshortcashandlongtherisklessbond.Instead ofusinginterestratederivativestohedge,theseBHCsamplifytheirinterestrateexposure. Insum,whileaccountingvariablesshowapositivecorrelationbetweenbankinterestnetincomeand theslopeoftheyieldcurve,evidenceusingstockmarketdataismixed. Observation6:NetincomemeasuresforBHCsarepositivelyrelatedtothetermspread. Thematuritystructuresoflifeinsurancecompaniesandpensionfundsdifferfromthoseofbanks.Their liabilitiesareverylongterm,oftenupto30years.Sincethesetoffixedincomeinstrumentswithsuch longmaturityislimited,theirassetsareofshorterduration.Figure4indicatesanegativerelationship betweenthe25yearto10yearTreasuryspreadandlifeinsurancecompaniesnetincome.
3.00% 30.00%

2.00%

25.00%

1.00%

20.00%

0.00%

15.00%

1978
1.00%

1985

1992

1999

2006
10.00%

2.00%

5.00%

Figure4:Lifeinsurancecompaniesnetincomecomparedtorelevantinterestrates. Toptobottom(leftaxis):Lifeinsurancenetincomeoverassets; (rightaxis):25yearTbond;10yearTnote;threemonthTbill;Michiganinflationexpectations. 13

3.00%

0.00%

Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Lifeinsurancecompaniesarenotsubjecttospecialaccountingrules,andtheydontmarktheirpositions tomarket.Hence,anychangeinthe25to10yeartermspreadwillrequiresometimetoshowupinthe netincomenumbers. InsuranceNI/Assets 25y10y(3) 25y10y(2) 25y10y(1) 25y10y Real3mTsy Intercept Coefficient 0.8454* 0.2028 0.2368 0.4622 0.1158* 0.0109*** StandardError 0.3570 0.4318 0.4288 0.4801 0.0604 0.0029 Rsquared 0.6552 25y10y(2) 25y10y(1) 25y10y Real3mTsy Intercept PensionFundingStatus Coefficient 16.9382* 2.1253 13.1257 7.5868*** 0.0483 StandardError 7.5490 9.3954 10.6505 1.4540 0.0644 Rsquared 0.8054 Table4:PanelAreportstheregressioncoefficientsofleveloflifeinsurancecompaniesnetincometo assetratioonthecontemporaneousandlaggedlevelofthe25to10yeartermspreadandshortterm realinterestrate.PanelBreportsthecoefficientsforthedifferenceinpensionfundingstatus. InTable4,PanelAreportstheregressioncoefficientofnetincomeoverassetsonthe25to10year termspreadwithvariouslagsandtheshorttermrealinterestrate.PanelBrepeatstheexerciseforthe fundingstatusofpensionfunds. Upwardparallelshiftsoftheyieldcurveboostthenetincomeofinsurancecompaniesandthefunding statesofpensions.However,awideningofthe25to10yeartermspreadtendstohurtslifeinsurance companiesandpensionfunds. Observation7:Whileforbanksthe10yeartothreemonthtermspreadwasmorerelevant,forlife insurancecompaniesandpensionfundsthelongerendoftheyieldcurve,i.e.,the25to10yearterm spread,mattersmost. Sofar,wehaveignoredtheimportantinterplaybetweenfundingliquidityontheliabilitysideand marketliquidityontheassetsideofbalancesheets.Thenextsectionsprovidetheconceptual underpinningsofdeeperanalysisandexplaintherolethatmonetarypolicycouldplaytomitigate redistributionalamplificationeffects.

3. The Three Phases of Financial Recessions

Thissectionprovidesatheoreticalframeworkbywhichfinancialrecessioncanleadtowealth redistributions.Withouttheory,itisimpossibletointerpretthestylizedobservationsmadeabove.The regressionslinkingexpenseorincomestatementswithinterestratesareespeciallyplaguedby endogeneityproblems.Interestratesarea(monetary)policyinstrumentandrespondtotheeconomic environmente.g.,tolossesinthefinancialsystem. 14

Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Financialrecessionsaretypicallyprecededbyaperiodofincreasingimbalances,boomingassetprices, andgrowingcredit.Thesubsequentfinancialrecessionsetsinmotionanumberofamplification mechanisms,whichoftenleadtosignificantandpersistentreductionsineconomicactivity.Recovery afterfinancialrecessionscanbeslowinlargeadvancedeconomies.

3.1 Boom Phase: The Runup

Financialrecessionsstemfromtheearlierbuildupofsystemicriskintheformofunsustainable imbalancesandbubbles.Theaccumulationoftheseimbalancescanbeattributedtoincentiveand beliefdistortions.Incentivedistortionsarisefrommoralhazardproblemscausedbyexpectedbailout policiesorsimplybecausemarketparticipantsfailtointernalizefiresaleexternalities.Forexample, whenleveringupwithshorttermdebt,eachspeculatortakesintoaccountonlythathemightnotbe abletorolloverhisdebtandmightbeforcedtoselloffassetsatfiresaleprices.However,thesame investordoesnottakeintoaccountthathissellingwilldepressprices,potentiallyforcingotherstosell aswell.Putdifferently,financialstabilityisapublicgoodandeachindividualtraderscontributionisless thansociallyoptimal. Inadequatedataandanecdotalevidenceofthistimeisdifferentthinkingmakeitdifficulttoruleout beliefbiases.Initially,boomscanberationalizedbyappealingtosomeformofinnovation.This innovationcouldbetechnologicalchange(e.g.,railroads,telegraph,theInternet),financialliberalization (e.g.,theremovalofRegulationQ),orfinancialinnovation(e.g.,securitization). However,astheimbalancesandbubblesgainmomentum,itultimatelybecomesclearthatthe fundamentalimprovementsthatmayhavewarrantedaninitialincreaseinassetpricescannotkeepup witheverincreasingvaluations.Eventhoughsomemarketparticipantsarepronetoextrapolative expectations,thequestionofhowsuchimbalancescanbuildupforsolongandwhatpreventsrational investorsfromcorrectingthemsoonerremains. Oneansweristhatindividualrationalmarketparticipantsfinditmoreprofitabletoridethetrendrather thanleanagainstitaslongasthemusicisplaying.Inasettinginwhichacorrectionoccursonlyaftera sufficientlylargenumberofmarketparticipantschangecourse,eachindividualwaitsforotherstomove. AbreuandBrunnermeier(2003)modelthissynchronizationproblem.Marketparticipantssequentially receiveasignalthatthecurrenttrajectoryisunsustainable.Eachmarketparticipantweighsthegain fromridingthetrendagainsttheriskofbeingcaughtintheinevitablecollapse.Inequilibrium,large imbalancesbuildupasagentsinitiallychoosetoridethetrend,andthecorrectionoccursonlyaftera significantdelay.Themainproblemisthatthenecessarycorrectionoftenoccursafterlargeimbalances havealreadydeveloped. Boomsfueledbycreditdeservespecialattention,sincetheburstingofcreditbubblesleadstomore deleveragingandstrongeramplificationmechanisms.Forexample,whiletheburstingofthetechnology bubblein2000triggeredsignificantwealthdestruction,itsimpactontherealeconomywasrelatively mildincomparisontotheGreatRecession.ThedistinguishingfeatureoftheGreatRecessionwasthe precedingcreditboom.Similarly,therunupinstockpricesduringtheRoaringTwentieswastoalarge extentbasedoncreditintheformofmargintrading,i.e.,itwasfinancedviashorttermloans.This 15

Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 creditfedboomultimatelyledtotheGreatDepression.Likewise,theScandinaviancrisisintheearly 1990sandtheJapaneselostdecadewerealsoprecededbylendingboomsthathadledto unsustainableassetprices. Thecoreofouranalysisandpolicyrecommendationsisderivedfromtheframeworkdevelopedin BrunSan(2011,2012).Wesketchthedetailsandmainimplicationsinthenextsection,butwillhighlight heretwoimportantresultsthatdirectlyrefertotherunupphase: 1. 2. volatilityparadox destabilizingfinancialinnovation

Thevolatilityparadoxreferstothephenomenonthatareductioninexogenousrisklevelmakesthe systemmorepronetowardsystemicvolatilityspikes.Thereasonisthatlowerexogenousriskinvites financialinstitutionstopayoutmoreindividendsandbonuses,therebyincreasingtheirleverage.This leadstohighersystemicrisk.Intheend,whatevertheexogenousfundamentalrisk,itisnormalforthe systemtosporadicallyentervolatileregimes.Lowriskenvironments,liketheGreatModeration,are conducivetogreaterbuildupofsystemicrisk.Inotherwords,alowvolatilityenvironment,inwhich financingiseasytoobtain,istheidealfoundationforacreditboom. Second,financialinnovationcanbeselfdefeating.BruSan(2011)considersasettinginwhichproductive institutionsareexposedtoidiosyncraticriskinadditiontomacrorisk.Somefirmsgobankruptwhen theysufferanidiosyncraticshock.Anticipatingpotentialbankruptcyandforeclosurecosts,bond holderschargeaspreadasacompensationfortheseexpectedlossesupfront.Onemightexpect financialinnovationthatallowsfirmstohedgeagainsttheseidiosyncraticriskswouldimprovefinancial stability.However,whenfirmscanhedgetheiridiosyncraticrisktheyfeelemboldenedandtakeon moreleverage,whichcanmakethewholesystemlessstable.Thus,whilesecuritizationandother financialinnovationsareostensiblyquitebeneficialinthattheydecreasethecostsofidiosyncratic shocksandreduceinterestratespreads,theycanunintentionallyleadtoamplifiedsystemicriskinthe economy.

3.2 Bust Phase: Liquidity and Deflationary Spirals

Afterthegradualbuildupofabubbleandtheassociatedimbalances,atriggereventcanleadtothe burstingofthebubble.ThetriggereventthatcatalyzesthecrisissometimesreferredtoastheMinsky momentdoesnothavetobeaneventofmajoreconomicsignificancewhenconsidered independently.Strategiccomplementaritiescanleadtoamplificationoreventomultipleequilibria,with thepossibilityofajumptoaParetoinferiorequilibrium.Insuchenvironments,evenamodesttrigger eventcancauselargespilloversacrossthefinancialsystem. Spilloverscanbedirectfromoneinstitutiontoitscounterparty,leadingtosocalleddominoeffects,or theycanbeindirect.Forexample,depositorbankruns,ortheirmodernreincarnationascounterparty runsinwholesalefundingmarkets,aredirectspillovers.Indirectspillovers,however,ariseeveniftwo partieshavenocontractuallinks.Theyworkthroughcommonriskexposuresthroughprices, constraints,andtheendogenousresponsesofmarketparticipants.

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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Tobetterillustratetheunderlyingmechanismandtodevelopaframeworkthatallowsustoevaluate variouspolicymeasures,wesketchheretheBrunSan(2011,2012)model. Anymodelthatstudiesfinancialinstabilityandtheroleoffinancialfrictionsmustdepartfromthe representativeagentanalysisandinvolveheterogeneousagents/sectors.Insteadoffocusingspecifically onthesectorsmentionedinSection2,BruSansplitsagentsintothreegroups:productiveagents,less productiveagents,andthefinancialsector.Interpretedliterally,entrepreneurscanbethoughtofas moreproductiveinoperatingapieceofequipment.Viewedmorebroadly,productiveagentsmightalso bethosewhoderivemoreutilityfromowningahouseorwhosimplyvalueitmorethanothers.They mightalsomorerisktolerant,lesspatient,youngerorsimplymoreoptimistic.Whatisimportantisthat someagentswouldliketoscaletheiroperations,i.e.,theircapitalholdings,beyondalevelthattheir ownfundingwouldallow. Anotherelementisthatfinancialfrictionslimitfundingandrisksharingamongagents.Forexample, directfinancialarrangementsarelimitedwhenthefundprovidercannoteffectivelymonitorthe borrower.SpecificallyinBruSan,contractscanbewrittenonthevalueofphysicalcapitalbutnotonthe (aggregate)efficiencylevelofcapital. Thefinancialsectorhasaspecial(monitoring)technologythatpartiallymitigatesthesefinancial frictions.4However,toalignincentives,financialfirmsarerequiredtohaveskininthegame.Thatis, similartothestaticsettingofHolmstrmandTirole(1997),thefinancialsectormustberesponsiblefor someoftheriskofendborrowers(productiveagents)inordertomitigatefinancialfrictions.Therisk bearingcapacityofthefinancialsectordependsonhowwellthefinancialsectoriscapitalized specifically,itdependsonitsnetworth.Ofcourse,iftheproductiveagentshavemorewealth,thenthey arealsoabletoscaleup.Thestateoftheeconomyisdescribedbythenetworthofthefinancialsector andthenetworthoftheproductivesector.Aggregatingthenetworthsharesofthefinancialsectorand endborrowersyieldsavariablethatstronglyaffectseconomicactivity.Whenislow,theeconomy becomesfinanciallyconstrained.Inspecialcases,becomestheonlystatevariableimportantfor systemdynamics. Whenthefinancialsectorissufficientlywealthy,competitiveforceserodeexpectedreturnsforfinancial firms.Atthatpoint,someofthebankerspayouttheirexcessnetworthandincreaseleveragetoboost returns.Increasedpayoutsimplyanupperlimitforthewealthshareofthefinancialsector.The theoreticallowerlimitofthefinancialsectorswealthshareisclosetozero. Theeconomyissubjecttoexogenousmacroshocksthataffecttheproductivityofphysicalcapital.Either fewer(ormore)goodscanbeproducedwiththesameamountofcapital,asinBruSan2011,orpartof thecapitalcanbemisappropriated,asinBruSan2012.Theseshocksaffectthereturnoncapital.Recall thatthereturnoncapitalislowerforlessproductiveagents,asphysicalcapitalheldintheirhands produceslessoutput.Inaddition,itmightdepreciatefasterbecausetheymaybelessabletomaintain thephysicalcapital.
InBruSan2012,financialintermediariesalsohavetheadvantageinbeingabletoholdadiversifiedportfolio acrossmanyproductiveagentsprojects.
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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Theequilibriumpriceofcapital,q,dependsontheaggregatenetworthshareofthefinancialsectorand endborrowers,whichmovesbetweentwoextremes0and*.Theupperpricelimitariseswhenthe financialsectoriswellcapitalizedand,therefore,capitalispurelyheldbytheproductivesector.When banksarelesswellfunded,theequilibriumprice,q,dropsasthedemandforcapitalgoodsdeclines.The lowerpricelimitariseswhenapproacheszeroandallcapitalisheldbythelessproductiveagents. Anadverseexogenousshockcanleadtosharppricemovementsbecauseofamplifyingadverse feedbackloops.Wefirstdiscussthreeliquidityspiralsbeforeanalyzingthedeflationaryspiral.Tobetter understandtheliquidityspiral,itisusefultodistinguishbetweenthreeliquidityconcepts. 1. Technologicalilliquidity Physicalcapitalisilliquidifinitialinvestmentisirreversiblethatis,whencapitalcannotbe convertedbackintoconsumptiongoods.Technically,technologicalilliquidityiscapturedby adjustmentcostsintheinvestmentfunction.Ofcourse,ifprojectsareshortlived,i.e.capital depreciatesveryfast,thentheyaredefactoreversible.Thedepreciationratecanbeviewedas thedurationofthecapitalgood. 2. Marketilliquidity Marketliquidityishighifcapitalcanbesoldofftootherswithoutalargepriceimpact. a. Physicalcapitalenjoyshighmarketliquidityifitcanbeeasilyredeployed,becauseits specificityislow.Inotherwords,ifithasahighsecondbestuse. b. Financialclaimshavehighmarketliquidityiftherearenorelatedinformational problems:i.e.,incentivesarealignedbetweenprincipalsandagents. 3. Fundingilliquidity Unliketechnologicalandmarketliquidity,fundingliquidityreferstotheliabilitysideofthe balancesheet.Fundingliquidityisprimarilydeterminedbythematuritystructureofdebtand thesensitivityofmargins/haircuts.Ifthemargincanjumpfrom10%to40%overnight,then 30%ofthemarginloanessentiallyhasthematurityofoneday. AliquiditymismatcharisesinBruSansinceshortterm(instantaneous)debtfundingisusedtofinance thepurchasesoflongdurationcapital.Capitalinvestmentdepreciatesonlyatrate(inthehandsof lessproductiveagents,atrate).Moreover,thetechnologicalliquidityofphysicalcapitalislow becauseof(dis)investmentadjustmentcosts.Inaddition,marketliquidityislowbecauseofthe productivitydifferencebetweenmoreandlessproductiveagents.Capitalfiresoldtolessproductive agentsisemployedonlyatitssecondbestuse.(Notethatliquiditymismatch,notmaturitymismatch,is important.Forexample,ifmarketliquiditywereperfect,thematuritymismatchwouldnotmatter.) Liquidityspiralsamplifyanyinitialadverseproductivityshock.Theamplificationdependsonleverage andfeedbackloopsthatariseaspricesreacttochangesinthenetworthofconstrainedagents. Interestingly,whenthefinancialsectoriswellcapitalized,financialfirmsreducepayoutsinorderto avoidassetsales.Thisstabilizesthepriceofcapitalanddampenstheadversefeedbackloop.However, whenthefinancialsectorislesswellcapitalized,furtheradverseshocksleadtofiresales.Asa consequence,thepriceofcapitaldropssignificantlyandwithitthenetworthofbanksandend borrowers.Theseverityofthelossspiraldependsontheinitialleverageofbanksandonthe 18

Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 productivitydifferencebetweenmoreandlessproductiveagents.Recallthatlessproductive householdsprovideaflooronthepriceofcapital,astheycanredeploycapitalinitssecondbestuse. Thefinancialsectorsleveragedependson1)thepayoutpolicyingoodtimes,and2)assetholdings. Whenchoosinghowmuchtopayoutintheformofdividendsandbonuses,eachfinancialfirmtrades offsafetywiththecostofretainingearnings.Holdingextrafundsinsidethefirmprovidessafety, especiallyina(endogenously)riskyenvironment,asfirmscansustainnegativeshockswithouttriggering assetfiresales. Inbadtimes,firmspayoutislimitedandtheirrisktakingdependsonthefollowingtradeoff.Whenthe networthofbanksislow,theirprofitopportunitiesarehighascompetitionisrestrained.Themarginal valueofanextradollarofnetworthishigh.Ontheotherhand,riskishighsincesubsequentnegative shocksdepresspricesevenfurther.Becauseoftheincreasedmarginalvalueofwealth,alowerchoiceof leveragewouldhaveledtoasuperioroutcome.Atanymomentintime,institutionsbalancethistrade offbetweenendogenousreturnandendogenousrisk.Astheirnetworthdrops,theyreducetheir holdingofcapitalassets.5 Themodelexhibitsinterestingendogenousvolatilitydynamicsduetosystemicrisk.Importantly, systemicriskdependsonagentsbehavioralresponsesandrisktakingdecisionsbothbeforeandafter adverseshocks.Themodelalsoexplainstheasymmetry(negativeskewness)ofbusinesscycles. OnecanextendtheanalysisofBruSan11andintroduceadditionalfundingliquidityrestrictionsthat explicitlydependonthevolatilityofthepriceprocess(see,e.g.,Phelan(2012)).Aspricevolatility increases,marginandhaircutrequirementstighten.Inthiscase,anadditionalliquidityspiral,i.e.,the margin/haircutspiral,emerges(seeBrunnermeierandPedersen(2009)).Highervolatilityleadstohigher margins,forcinginstitutionstosellmorecapital.Theresultingsharperpricemovements,inturn, increasevolatilityandadversefeedbackobtains. BruSan2012addsmoneytotheanalysisinordertostudytheinteractionbetweenfinancialstabilityand pricestability.ThemodelallowsonetostudytheFisherdeflationaryspiralanditsinteractionwiththe liquidityspirals.Unlikecapital,whichisrisky,moneysroleisasasafestoreofvalue.Outside(fiat) moneyisissuedbythegovernmentanditsvalueisdeterminedendogenously.Insidemoneyisissuedby thefinancialsectorintheformofshorttermnominaldebtobligations. Again,letusstartwiththetwoextremescenarios:1)whenthefinancialsectorisclosetobankruptcy andhenceessentiallyabsent,and2)whenthefinancialsectorisextremelywellcapitalized.Inthefirst case,agentscanholdcapitalfortheirownenterpriseandmoney.Productiveagentsarewillingtohold primarilyphysicalcapital,whilelessproductiveagentstilttheirportfolioprimarilytowardlessrisky money.Whileallagentsearnthesamereturnfromholdingmoney,productiveagentsearnhigher returnfromcapital.Inthesecondextremecase,thefinancialsectorhasalargeriskbearingcapacity.

InBruSan,activeinstitutionsnetworthisalwaysnonnegative.Hence,theydonotgambleforresurrectionas wasarguablythecaseduringtheS&Lcrisis.IntheongoingGreatRecession,exposurereductionsweremore prominent.Bankscouldmoreeasilyextractmoneywithdividendandbonuspaymentsthanbygamblingthrough riskyinvestments.

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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Thefinancialsectorfundsitselfthroughshorttermnominaldebt,i.e.,byissuinglargesumsofinside money,andchannelsthefundstotheproductivesector.Itisassumedthat,unlikeagentswhocan investonlyintheirownenterprise,thefinancialsectorcandiversifyacrossproductiveagentsprojects. Asbefore,theextenttowhichlessproductiveagentsarewillingtofundthefinancialsectordependson banksriskbearingcapacity.Thefinancialsectorfacesaskininthegameconstraint.Awellcapitalized financialsectorcanchannelsufficientfundstotheproductivesector,improvingresourceallocationin theeconomy.Thisalsoleadstomoredemandforandahigherpriceofphysicalcapital,q.Ontheother hand,thepriceofmoney,p,isnowlowersincetheextrasupplyofinsidemoneycreatedbythefinancial sectorcompeteswithoutsidemoneysupply. Next,consideranadversemacroshock.Asbefore,theliquidityspiralcreatesadverseeffectsonthe priceofcapitalandintermediariesnetworth.Now,however,thereductioninthefinancialsectorsnet worthhasasecondimportanteffect.Asthefinancialsectorcutsbackitsexposuretosatisfyitsskinin thegameconstraint,itissueslessinsidemoneyjustasproductiveagentsareforcedtoselloffphysical capitaltolessproductiveagents,depressingthepriceofcapital.Themoneymultipliercollapses.Overall moneysupplyintheeconomyshrinks.6Hence,thevalueofmoneyincreases,i.e.,deflationarypressure emerges. Asdeflationincreasestherealvalueofthefinancialsectorsliabilitiesandtherebyreducesitsnetworth evenfurther,adeflationaryspiralarises.Becauseofthesetwospirals,anegativeshockhitsthefinancial sectoronbothsidesofthebalancesheet.Ontheassetside,theliquidityspiraldepressesassetprices andreducesthebanksnetworth.Ontheliabilityside,therealvalueofliabilitiesactuallyincreasesafter anegativeshock,leadingtofurthererosionofnetworth.Bothspiralsamplifytheoverallimpactofthe initialexogenousshock.Notethatholdingmoneyisattractivealsoforhedgingreasons,asintimeof crisisthevalueofmoneyincreasesasaresultofdeflationaryforces. Twoimportantinsightsemergefromthisanalysis,whichwillalsoguideourpolicydiscussioninthenext section: First,financialintermediariesimposeanegativeexternalityoneachother.Aseachintermediary delevers,itdoesnotinternalizeitscontributiontoeithertheassetpricecollapseorthe deflationarypressure. Second,spiralsafteranadverseshockcauselargeredistributionsawayfromthebankingsector. However,thisredistributiondoesnotbenefitotheragents;rather,itleadstoanoverallwealth destructionduetoinferiorresourceallocation.

Sofar,anadverseshocksimplyreducesthemoneysupplyasthemoneymultipliercollapses.Inasetting withnonlogutilityfunctions,moneydemandcanalsoincreaseintimesofcrisisastheprecautionary savingsmotiveincreases.Atthatpoint,demandforanysafestoreofvaluewouldincreaseevenmore.

SuchacollapseoccurredduringtheGreatDepression,creatingpainfuldeflationwithlonglastingeffectson borrowers.However,thisexperiencecontrastswiththatoftherecentfinancialcrisis,wherethemoneymultiplier collapsewasoffsetbyatremendousincreaseinthemonetarybase.
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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Thedemandforotherassetsthoughttobesafewouldriseaswellinthisflighttosafety.Thatis,asset priceinflationsetsin,whiletheCPIfalls. Toallowforopenmarketoperations,BruSan2012introducesaperpetualgovernmentbondthatpaysa fixednominalamountofinterestineveryperiod.Abroadmoneymeasurethenincludesnotonlyshort termmoneybutalsothisgovernmentbond.Ifthereisadangerthatthegovernmentmightdefaulton longtermbonds,adiabolicloopbetweensovereignandbankingriskarises.Furthermore,themonetary transmissionmechanismcouldbeimpaired.Section4focusesonpolicyresponsesanddiscussesthese aspectsinfurtherdetail.

3.3 Recovery Phase

Recoveryfromfinancialrecessionscanbesluggishandprotracted.Sectorswhosefinancesareimpaired devotetheirresourcestorepairingbalancesheets.AftertheburstingoftheJapaneserealestateand stockmarketbubble,thenonfinancialbusinesssectorscaledbackinvestmentsandfocusedonpaying offdebt.Currently,intheUnitedStates,householdsarescalingbackconsumptiontoaccumulate savings.Inaddition,thefinancialsectorisslowlyrecapitalizingitselfthroughretainedearningstosatisfy highercapitalrequirements. BernankeandGertler(1989)wrotethefirsttheoreticalpapertohighlightthepersistenceofbalance sheetrecessions.Intheirwork,thecorporatesectorreturnstonormalsteadygrowthonlyafteralong periodofrecapitalization.InBernanke,Gertler,andGilchrist(1999)andKiyotakiandMoore(1997),this persistenceintothefutureaffectscurrentassetpricesandhencefeedsback,exacerbatingtheinitial amplificationeffect.BruSan2011givesafullcharacterizationofthevolatilitydynamics.Whilethesystem isrelativelystablewithreasonablegrowthinthenormalregime,itcanbethrownoffandtrappedfor sometimeinarecessionwithlowgrowthandlowmarketliquidity.Thishappensaftermovingthrougha highvolatilityregion.ThestationarydistributioninBruSan2011isUshaped,implyingthatthesystem spendsmostofitstimearoundthesteadystate,transitionsveryspeedilythroughtheintermediate regionwithhighvolatility,andalsospendsaconsiderableamountoftimeinthedepressedregimewith lowgrowth. Empirically,theprofessionhasnotsettledthequestionofhowfastrecoveryoccursafterfinancial recessions.ReinhartandRogoff(2009)defineaslumpastheperiodfromthepeakinGDPpercapitato thedateatwhichthatpeakisregained.Theyprovideempiricalevidenceforasluggishrecoveryphase. BordoandHaubrich(2012)arguetothecontrary,measuringthespeedoftherecoverybyitsslope.For theU.S.,onlytheGreatDepressionandGreatRecessionstandoutasslowrecoveries. Thespeedyrecoveryofemergingmarketeconomiesafterasuddenstopofcapitalinflowcoinedas thePhoenixMiraclebyCalvo,Izquierdo,andTalvi(2006)alsoseemstocontradicttheabove mentionedslowrecoveryhypothesisoffinancialrecessions.Acloserlook,however,revealsthatakey foremergingmarketrecoveryisexportgrowthresultingfromrealexchangeratedepreciation.This leadstohighergrowthinoutput,workingcapital,andtemporaryemployment.However,despitethe realexchangeratedepreciation,creditandlongtermemploymentarealsosubduedinemerging

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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 markets.Overall,theempiricalevidencesuggeststhattheeffecthastointeractwithsomeother variables,suchashousingdebtorforeignexchange.

4. Monetary Policy
Carefullydesignedpolicycanreducethefrequencyoffinancialrecessionsandminimizeinefficiencies oncetheyhappen.Ouranalysissuggeststhatsomeseeminglynaturalpolicyresponsescanactuallybe counterproductive.Importantly,contrarytopredominantview,thethreeobjectivesofpricestability, financialstability,andfiscalgovernmentdebtsustainabilitycannotbetreatedindependentlyfromeach otherandassignedseparatelytomonetary,regulatory,andfiscalauthorities,respectively.Theyareall closelyinterlinked. Thefirstpartofthissectionlooksattheoptimalmonetaryresponsetoanadverseshock,whilethe secondpartstudiesmonetarypolicyrulesfromanexanteperspectivewithaspecialfocusonmoral hazard.Section5dealswithfiscalpolicyandrestructuringpolicy.

4.1 Monetary Policy Response to Adverse Shocks

Mostcentralbankshavethefollowingmonetarypolicytoolsattheirdisposal:1)shortterminterestrate policies,2)helicopterdropsofmoney,3)assetpurchaseprograms,and4)collateralpoliciesfor lendingprograms.(EquityinfusionsandotherrestructuringpoliciesarediscussedinSection5.2.)The effectivenessofthesetoolsdependsonthecentralbankscredibilityaboutitsfuturebehavior conditionalonthestateoftheeconomy. MostmacroeconomicmodelsemphasizetheKeynesianinterestratechannel.Thekeyfrictioninthese modelsissomeformofpriceorwagestickiness.Loweringthenominalinterestrateleadstoalowerreal interestrate.Alowerrealinterestratestimulatesaggregatedconsumptionandinvestmentasthe representativeagentbringsconsumptionforwardandinvestmentprojectsbecomemoreprofitable.In NewKeynesianmodels,interestratesaresetbyarulee.g.,theTaylorruleandmoneyservesonlyas aunitofaccount.Thezerolowerboundofthenominalinterestrateisanimportantrestrainingfactor andthemainjustificationfornonconventionalmonetarypolicyandfiscalmeasures. TheITheoryofMoneyinBruSan2012stressesanewchannel:theredistributionalchannelofmonetary policy.Insteadofpricestickiness,financialfrictionsarethesourceofinefficiencies.Monetarypolicy leadstochangesinvariousassetpricesandthevaluesofdebt/mortgagecontracts.Thismonetary transmissionchannelworksprimarilythroughcapitalgains,asintheassetpricechannelpromotedby Tobin(1969)andBrunnerandMeltzer(1972).Lowerinterestratescanalsoincreasetherisktaking behaviorofinvestorsandassetpricedistortions,asshowninAdrianandShin(2011). AnimportantelementinBruSan2012isthatassetholdingsarenotsymmetric,andhencemonetary policyaffectsdifferenteconomicagentsdifferently.Asaconsequence,monetarypolicyredistributes wealth.Thisredistributiveeffectcanmitigatedistortions,suchasdebtoverhangproblemsthatarise fromamplificationmechanismsdescribedinSection3.Thesemitigatingeffectscanspurgrowthand 22

Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 leadtoanoverallhigherwealthlevelintheeconomy.Forspecificscenarios,monetarypolicycaneven leadtoParetoimprovements,makingallagentsintheeconomybetteroff.Wethereforerefertothese effectsasrelativewealthredistributionstostressthatredistributioninoursettingisnotazerosum game. Tostudymonetaryanalysis,wehavetoaddimportantelementstothebarebonesmodelof BruSan2012describedinSection3.First,acentralbankinBruSan2012paysinterestonreserves (outsidemoney),whichmirrorstheinstitutionalframeworkintheeurozoneandintheU.S.sincethefall of2008.Inthemodel,theseinterestpaymentsarefullyfinancedbyseigniorage.Inotherwords,any interestpolicyisfullyfinancedandbudgetneutralatanypointintime.Varyingtheshortterminterest rateisthekeyconventionalmonetarypolicytool. Conventional Monetary Policy Conventionalmonetarypolicycaninfluencewealthdistributionintwoways.First,loweringtheshort terminterestratereducesbanksfundingcosts.Ifcompetitionamongbanksislimited,banksarenot forcedtopassonthecheaperfundingcoststotheircustomersandhenceareabletoincreasetheir profitmargins.Theincreaseinnetinterestmarginsisaslowwaytorecapitalizebanks.Englishetal. (2012)showthatbanksinterestincomeistypicallyhigherinalowinterestrateenvironment. RedistributionaleffectsofmonetarypolicyweredebatedinJapaninthemid1990swhentheBankof Japanadoptedalowinterestratepolicy.7 Second,interestratepolicycanaffectassetprices.BruSan2012focusesontheredistributionaleffects causedbyassetpricemovements.Thepaperintroducesalongtermbondspecifically,aconsolbond withinfinitematuritythatpromisesnominalinterestpayments.Now,interestratepolicyhasanimpact becauselowshortterminterestratesincreasethevalueoflongtermbondsandredistributewealthto longtermbondholders.Inthemodel,thecentralbanksimplyreducestheinterestitpaysonoutside money(reserves)tolowertheshortterminterestrate.Inreality,centralbanksmightalsohaveto conduct(relativelysmall)openmarketoperationsthatexchangeshorttermmoneyforlongtermbonds toensurethatthenewshorttermratetargetisreached.InBruSan2012,thesectorthatisexposedto theliquidity/deflationspiralriskholdsthelongtermbond,whenitexpectspolicyresponsestocause theappreciationofthesebondsindownturns.Hence,anaccommodativeinterestratepolicyafteran adverseshockpartlyoffsetsthenegativewealthshocks.Thiscanbereferredtoasa"stealth recapitalization"becauseitisawaytoredistributewealthtowardthedistressedsector. Notethatthisframeworkemphasizesmoneyasastoreofvalue.Bothshorttermmoneyandlongterm bondsarestoresofvalueandhencearepartofthetotalbroad(outside)moneysupply. Forconventionalmonetarypolicytocontrolthelongtermyield,i.e.,toachieveashiftinthelongterm bondprice,itisnecessarythatthecentralbankcrediblycommittoalowinterestrateuntiltheeconomy strengthensagain.
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Forexample,Ono(1997)findsnodirectincometransfersfromdepositorstobanks.Banks surgeinprofitwasprimarilyduetocapitalgainsinlongtermfixedratebonds.
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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Unconventional Monetary Policy Unconventionalmonetarypolicycantakeondifferentforms.First,thefamoushelicopterdropof shorttermmoneyorlongtermbonds(whichhasafiscalcomponenttoit).Iftheextramoneysupplyis targetedataspecificsector,thatsectorwillbenefitthemost.Buteveniftheextramoneyisdistributed symmetricallyamongalleconomicagents,thosethatholdnominalclaimssuffercomparedtoagents thatownrealprojects,becausetheoverallpriceleveladjusts.Therelativeredistributionoccurs betweennominalandrealclaimholders. Second,assetpurchaseprogramsdirectlybenefittheholdersoftheseassets.Forexample,longterm bondyieldsaredeterminedbybothcredibleshortterminterestratepolicyandbondpurchase programs.Forexample,ifabondpurchaseprogrammakesitmoredifficult(easier)tocommittoalow interestrateenvironment,theoverallimpactofshortterminterestratesonthelongtermyieldmight bemuted(larger).KrishnamurthyandVissingJorgensen(2011)trytoquantifytheimportanceofvarious channelsoftheFederalReservesquantitativeeasingprograms. Thecentralbankcanalsopurchaseother,moreriskyassets.Bydoingso,thecentralbanktakeson (upsideanddownside)risk.Forexample,thecentralbankcouldpurchaseriskyclaimsorcapitaldirectly, asinBruSan2012.Iftheassetpurchaseprograminvolvesrealclaims,thenthemoneysupplyincreases. Thisalsoinducesarelativeredistributionbetweennominalandrealclaimholders.Notethateven nominalbondswithdefaultriskcanhavearealcomponentifthedefaultprobabilitydependsonthe pricelevel. Lendingprogramsarethethirdformofnonconventionalmonetarypolicy.Centralbankshavelenderof lastresortrole,Bagehot(1877).8Theseprogramsaresubsidizedlendingarrangementswiththepurpose ofinducingcertaininvestorstopurchaseorholdontoparticularassets.Thisprovidesapricesupportfor theseassetsanddirectlybenefitsthepreviousholdersoftheseassets.Investorswhotakeadvantageof thisprogrambenefitonlytotheextentthattheydonotcompetetherentsaway. Unlikewithstraightassetpurchaseprograms,withlendingprogramsthecentralbankassumesonly downsidetailrisk.Theriskmaterializesonlyifboththevalueoftheunderlyingcollateralfailstocover theborrowedamountandtheborrowingpartydefaults.Byvaryingthecollateralrequirements,the centralbankassumesmoreorlesstailrisk. Whenismonetarypolicymostwelfareenhancing?AsoutlinedinSection3,absentanymonetary intervention,anadverseshockleadstofiresalesofphysicalcapitalfromproductivetolessproductive agentsand,inaddition,todeflationarypressure.Monetarypolicythatisaccommodatinginthesestates oftheeconomyprovidessupportforthepriceofcapitalandotherassets.TheanalysisinBruSanshows thatthisismostwelfareenhancingif 1. marketliquidityofcapitalislow,sincethedifferencebetweenproductiveandless productiveagentsislarge,and

Inourframeworkfinancialandpricestabilityarecloselylinkedandweconsiderfinancialstabilityinstrumentsas partofmonetarypolicyinstruments.
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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 2. thelevelofexogenousvolatilityislow.

Intuitively,iftheproductivitydifferencebetweenagentsislarge,thenreallocatingphysicalcapitaltothe lessproductiveagentsdestroysmorewealth.Inaddition,thelargerpriceimpactoffiresalesamplifies theliquidityanddeflationaryspirals.Insuchanenvironment,endogenousriskisveryhigh.When exogenousriskislow,theresourcesrequiredtoeffectivelystabilizethesystemarelow,andhence monetarypolicycanhavethegreatestbenefit. Theresponsivenessofmonetarypolicydependsonthequantityandmaturityofoutstanding governmentdebtandotherlongdatedassets,aswellasonwhethermortgageinterestratesare primarilyfixedorfloating.Forexample,iftheailingsectorholdsmorelongdatedassets,thenasmaller interestratecutmightsufficetogeneratethesamecapitalgainseffect.Surprisingly,interestrate derivativesthatinsulatebanksfrominterestrateriskmakemonetarypolicylesseffective.However, thereisevidencethatlargebankholdingcompaniesusetheseinterestratederivativestoamplify interestrateriskratherthanreducethisrisk(seeBegenauetal.(2012)). Linking the I Theory of Money with the Fiscal Theory of the Price Level: A Diabolic Loop Sofar,wehaveassumedthatthegovernmentbudgetisalwaysbalancedandhencegovernmentdebtis sustainable.Indeed,thegovernmentsonlyexpensewastheinterestpaymentsonreservesfinancedby seignorage.Sincereservesarearelativelysmallpartofthetotalmoneysupply,thisisnotadominant effect.Next,weenrichtheenvironmenttoallowforthepossibilityofgovernmentdebtbecoming unsustainablei.e.,aftertheeconomysuffersanadversegrowthshock.ThisallowsustobridgetheI TheoryofMoneywiththeFiscalTheoryofthePriceLevelandtostudyinflation,capitalflight,andthe diabolicloopbetweensovereignandbankingrisk. Whengovernmentdebtbecomesunsustainable,therearethreepossibleregimes.Inthemonetary dominanceregime,themonetaryauthorityisinthedriversseatinthesensethatadverseshocksare mitigatedbyfiscalspendingcutsinordertoreturntoasustainablefiscalspendingpathandstabilizethe valueofthecurrency.Inthefiscaldominanceregime,thefiscalauthoritydeterminesgovernment spending.Indoingso,ithasalargeimpactoninflation,andthemonetaryauthorityisdefactonotinfull controlofinflation.Proponentsofthisfiscaltheoryofthepricelevelliteraturequestionwhethera centralbankcaneverbeindependentofthefiscalauthorities.9Thethirdregimeinvolvesadefaulton governmentdebt.10Ofcourse,exante,therecanbepolicyuncertaintyaboutwhichregimewill materialize.Thispoliticaluncertaintyaddsanotherlayerofendogenousrisk. Ifthemarketexpectsthat1)thegovernmentwillnotrestrainitsfiscalspendingand2)thecentralbank willnotmonetizetheunsustainablepartoffuturegovernmentexpenditures,thenlongtermbondsare subjecttodefaultandthedifferencebetweensovereignandprivatedebtclaimsvanishes.Inother words,governmentbondslosetheirmoneynessastheirroleasastoreofvalueiscompromised.The
FurthercomplicationsariseintheEuropeancontext,inwhichacentralbankhastodealwithseveralfiscal authorities.See,e.g.,Sims(1999)andCanzonerietal.(2010). 10 Governmentsoftendefaultinmoresubtlewaysontheirobligations.Forexample,theymayforcepublicly ownedpensionfundsandbankstoholdgovernmentpaperatunfavorablerates.Theseandothermeasuresgo oftenundertheheadingFinancialRepression.
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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 overallsupplyofsafeassetsdrops.Asimilareffectoccursfordemanddeposits,whendemanddeposit insuranceisnotsufficientlyfunded. Animmediateconsequenceofthisuncertaintyisaflighttosafety.Whenthegovernmentbondlosesits safeharborquality,investorswillshifttootherstoresofvalue,suchasforeigngovernmentbondsor gold.Whichforeigngovernmentbondsareconsideredtobesafedependsonforeigncountriesdebt sustainabilityandinstitutionalarrangements.Assafeassetsareanequilibriumphenomenon,some assetscanbeconsideredsafeowingtoselffulfillingexpectations.Ifotherinvestorstendtobuya certainassetintimesofcrisis,thenthehighervalueofthisassetcanbemoreeasilysustained.Aclassic exampleisgold,whichhasbeenasafeharborforthousandsofyears.Itsvaluerisesintimesofcrises eventhoughthefundamentalvalueofgoldisnotstronglytimevarying. Ifthefinancialsectorholdsalotofgovernmentdebt,thediabolicloopbetweensovereigndebtand bankingdebtcanexacerbatethesituation.Thereareatleasttwospiralsatworkhere.Astherealvalue oflongtermbondsdrops,thefinancialsectorcontractsitsbalancesheet.Theresultingcreditcrunch stiflesrealeconomicgrowth.Lowereconomicgrowthlowersthetaxrevenueforthesovereign,making adefaultormonetizationofgovernmentdebtmorelikely.Atthesametime,thefinancialsectormight needtoberecapitalizedbythegovernment.11Theincreasedprobabilityofabailoutmakesitlesslikely thatthegovernmentwillbeabletohonoritsolddebt.Inaddition,deflationaryandinflationary pressuresareatwork. Anegativeshockonsustainabilityofgovernmentdebtcantriggerbothdeflationaryandinflationary forces.Mechanismsthatleadtodeflationarenotthesameasinflationarymechanisms.Inotherwords, deflationisnotsimplynegativeinflation.TheFisherdeflationaryforceoutlinedinSection3ariseswhen acriticalsector,e.g.,thefinancialsector,issuddenlyundercapitalized,possiblybecauseofadropinthe realvalueofgovernmentbondsheldbybanks.Ifbondpricesdroponfearsofdefaultbythefiscal authorities,thendeflationaryforcescanbeverypowerful.Ifthebondpricesdroponexpectationsof governmentdebtmonetization,theninflationaryforcesareprevalent.Atthesametime,thefinancial sectorwillcontractifitholdsalargequantityofthisdebt.Thisleadstoanopposingdeflationarypush, butalsotoadeclineingrowth.Thelattermakesthegovernmentdebtevenlesssustainable,requiring evenmoremonetizationandinflation. Inaddition,weshouldalsodistinguishbetweendifferenttypesofinflation.Inflationcanbehelpfulto overcomedebtoverhangproblemsifitdevaluesdebtandbooststhenominalincomeoftheeconomic agentsclosetodefault.Ontheotherhand,costpushinflation(e.g.,duetohigheroilprices),ifnot accompaniedbyhigherwagegrowthofindebtedhouseholds,iscounterproductive. Furthermore,flightstosafetytootherdomesticassetsleadtoassetpriceinflation.Flighttosafetyto foreignassetslowerstheexchangerate,makesimportsmoreexpensive,andhenceincreasesCPI inflation.

ThisdiabolicloopisveryprevalentintheongoingEuropeancrisis.SeeEuronomics(2011)fortheirESBies proposalthatalleviatesthisproblem.
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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Insummary,duringcrisestimes,theopposinginflationaryanddeflationaryforcesareverypowerful.12 Balancingtheseforcestotargetpricestabilityisespeciallychallenging.Thesystemisnotveryforgiving: Smallpolicymistakescanleadtheeconomytodriftontoaninflationaryordeflationarypath.In addition,asmarketparticipantsfinditdifficulttopredictfutureinflation,investmentdeclinesand growthishindered.Traditionaltransmissionmechanismsareimpairedasinformationaboutpotential defaultormonetizationtakesprecedenceoverinterestratedecisions.

4.2 Monetary Policy Rules

Sofar,wehavefocusedonmonetarypolicyresponsesfollowingshocks.Inthissection,wetakeonestep backandanalyzehowapolicyruleshouldbedesignedfromanexanteperspective.Independentof whethermonetarypolicytriestomitigatefinancialfrictionsorpricerigidities,anygeneralmonetary policyrulemusttakeintoaccounthowitaffectseconomicagentsbeliefs.Viewedmoreabstractly,ifa centralbankcanperfectlycommittoarule,thentheoptimalpolicyruleissimplytheresultofacomplex implementation/mechanismdesignproblem.Theintentoftheruleistoaffecttheeconomicagents beliefsandbehaviorinordertosteertheeconomytowardthesociallydesirableobjective.Before discussinghowsuchrulesaffecteconomicagentsbehavior,includingmoralhazard,wecontrastthe twodifferentobjectivesmonetarypolicycouldhave:mitigatingdistortionsthatresultfromfinancial frictionsorfrompricerigidities. Financial Friction View Inaneconomywithfinancialfrictions,marketsareincomplete.Financialfrictionspreventagentsfrom insuringeachotheragainstshocks.Hence,shocksleadtoshiftsinthewealthdistribution.Initialshocks canbeamplifiedthroughpricemovements,andalargepartoftheriskisendogenous.Redistributional monetarypolicycanmitigatethesewealthshifts.Bydoingso,italsoreducesendogenousriskand stabilizestheeconomy.Inotherwords,apredictableandwellcommunicatedmonetarypolicyrulecan provideamissingsocialinsurancecontractacrossvariouseconomicagents.Itactslikeacontingent wealthtaxthattemperswealthshifts.Inthisprocess,itreducesendogenousrisk,enablesmorefunding tobechanneledtoprofitableprojects,andstimulatesgrowth. Viewedinamultiperiodsetting,monetarypolicyredistributeswealthalongthewholemultiperiod eventtree.Atanypointintime,future(contingent)redistributionofwealthcanbeviewedascurrent redistributionofrisks.Byconductingcertainmonetarypolicymeasures,thecentralbankassumestail risk.Forexample,whenlendingtofinancialinstitutionsagainstcollateral,thecentralbankassumesrisk inthestateoftheworldinwhichthecounterpartygoesbankruptandthecollateralvaluefallsshortof theborrowedamount.Strictlyspeaking,thecentralbankisnotassumingthetailriskbutsimply redistributingittoothersprimarilytothosewhoholdnominalclaims.Again,indoingso,theoverall riskmaybereduced.Hence,thisisredistributiononlyinarelativesense.Inanabsolutesense,itis possiblethatthewellbeingofalleconomicagentswillbeimproved.

12

SeealsoLeijonhufvud(2012).
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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Ofcourse,anyformofinsuranceleadstomoralhazard,asagentschangetheirexpectationsand behavior.Someofthechangesaredesirablebecausetheyreduceendogenousrisk.Othersareexcessive andhavetobeaddressedwithmacroprudentialregulation. Price Stickiness View: A Contrast Beforewedealwiththemoralhazardquestion,itisworthcontrastingthefinancialfrictionviewwith astylizedNewKeynesianperspective.Thereareatleastthreemajordifferences. First,thekeyfrictionispricestickiness,notfinancialfrictions.Tosharpenthecontrast,letusfocuson NewKeynesianmodelsinwhichmarketsarecomplete,andhencearepresentativeagentanalysisis justified.Themainroleofmonetarypolicyinthesemodelsistoovercomedistortionsthatarisefrom thepricerigidity.Monetaryrulestrytoinfluencethebehaviorofpricesetters,whichinturninfluence thereactionofothereconomicagentsandtheresponseofoutputtorealshocks.Asbefore,adheringto policyrulesisimportanttoensurethateconomicagentscanformreliableexpectationsandtheir reactionmaximizesthedesiredobjective. Second,theNewKeynesianparadigmfocusesontheroleofmoneyasaunitofaccount.Asa consequence,interestraterules,liketheTaylorRule,fullycharacterizemonetarypolicy,andmoney onlyplaysaroleinthebackground(seeKing(2002),Woodford(2003)).Incontrast,theItheoryandthe workbyKiyotakiandMoore(2008)focusonmoneyasastoreofvalue.Thelatternaturallyintegrates unconventionalpolicymeasuresandmacroprudentialtoolsinthemonetaryanalysis. Third,NewKeynesianmodelswithcompletemarketsfocusonasingleinterestrateanditsdeviation fromthenaturalrate.Financialfrictionsnecessitateariskcomponentandnotsimplyanintertemporal perspective. Wenowreturntothefinancialfrictionviewofmonetarypolicyanddiscussthepotentialofpolicyrules increatingmoralhazard. Moral Hazard: Interaction with Macroprudential Regulation Likeanyinsurancescheme,expostredistributionalmonetarypolicycomesatagreatprice:moral hazard.Economicagentsmightrespondtoanticipatedconditionalredistributioninunintendedways. Forexample,financialintermediariesmighttakeontoomuchrisksincetheyanticipatethatanyadverse shockwillthenbemetwithsomeaccommodativemonetarypolicythat(implicitly)recapitalizesthem. Thismakesthesystemexantemoreriskyandunderminestheoverallobjective. Hence,exante,thecentralbankwantstocommititselftolimittheredistributiveaspectsofmonetary policy.Expost,itwouldliketoredistributewealthtostimulatetheeconomy,butthisunderminesthe credibilityoftherule.Thecentralbankfacesaclassictimeinconsistencyproblem.Undercertain circumstances,themoralhazardproblemmaybesoseverethatthecentralbankiscorneredand forcedtoabandonitsrulebookaltogether.Whenthishappens,thecentralbanklosescredibility,andits abilitytosteertheeconomyisimpaired.

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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Thecentralbankcanbecorneredby1)fiscalauthoritiesand2)systemicallyimportanteconomic agents.Fiscalauthoritieswilltrytoforcethecentralbanktomonetizegovernmentdebtinorderto avoidpoliticallyunpopularausteritymeasures.Brinksmanshipbetweenproponentsofmonetary dominanceandproponentsoffiscaldominanceleadstouncertaintyintheeconomy.Theaimofany centralbankshouldbetomonitorthefiscalsituationinordertoavoidbattlesbetweenfiscaland monetaryauthorities. Toavoidbeingcorneredbysystemicallyimportanteconomicagents,suchaslargefinancialinstitutions, centralbankshavetwotypesoftoolsattheirdisposal:1)acleverdesignofexpostrecapitalizationrules thatreducemoralhazardproblems,and2)exantemeasuresthatleanagainstthebuildupofsystemic risk. Forexample,anexpostrecapitalizationschemethatpunishestheworstperformersoverothersinthe samesectormitigatesmoralhazardconcerns.See,e.g.,FarhiandTirole(2012)foramodelinwhich thesestrategiccomplementaritiesarise.AnextendedversionofBruSan2011studiesthecaseinwhich eachinstitutionisrecapitalizedinproportiontoitsnetworthaftertheshock.Thatis,institutionsthat hadlowerleverageandhencesufferedlessfromtheadverseshockbenefitmorefromtheexpost recapitalization.Theanalysisshowsthatsuchasimple,bluntschemekeepsmoralhazardproblems undercontrol.However,suchabluntmacrointerventioncomesatacost.Itrequireslargerexpost redistributionthanamoretargetedexpostmicrointerventionthattargetstheweakestinstitutions. Interestingly,monetarypolicy,ifemployedappropriately,canbeacleverredistributionarytoolin specificenvironments.Forexample,inBruSan2012aninterestratecutbenefitsthewholeintermediary sector,butespeciallythosewhoseportfoliosaretiltedtoward(defaultfree)governmentbondsand awayfromriskyinvestments.Thisgivesintermediariesanincentivenottoleveruptoomuchpriorto thecrisis. Thegoalofexantemeasuresistobuilduplargersafetycushionsinnormaltimestoleanagainstthe buildupofsystemicrisk.InBruSan2012,aninterestrateincreaseleadstocapitallossesonfinancial intermediariesbondpositions.Asaconsequence,financialintermediariesreducetheirbonusand dividendpayments.Ahigherinterestratealsogivesthecentralbankmoreroomforfuturestabilizing interestratecuts. Arguably,evenmorepowerfulexantepreventivepolicytoolsarethemacroprudentialmeasures,such asloantovalue(LTV)ratiolimitsandleverageandcapitalrequirementsthatworkthroughexplicit quantityrestrictions.LTVratiosareapowerfulmacroprudentialtoolforhouseholdsinmanycountries (see,e.g.,Wongetal.(2011)).TheJapaneserealestateandstockmarketbubblewasbroughtdownby totalvolumecontrol,ameasureimplementedinApril1990andterminatedinDecember1991.It limitedthegrowthrateofrealestatelendingtothegrowthrateofoveralllendingintheeconomyand forcedbankstoreporttheirlendingtotheconstructionandnonbankfinancialindustries.BruSan2011 studiestheeffectsofleverageconstraintsandshowsthattheyarecounterproductiveiftheyarenot countercyclical.

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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Leverageconstraintshavebothstabilizinganddestabilizingeffects.Intimesofcrisis,theyare destabilizing,asleveragelimitsamplifytheleverageanddeflationaryspiralsdiscussedinSection3.In goodtimes,thefearofdestabilizingspiralsleadstolowerpayoutsandhencealargersafetycushion. TheanalysisinBruSan2011showsthatthesecondstabilizingeffectissmallcomparedtothe destabilizingeffect.Itisthereforeimportantforthesemacroprudentialtoolstobecountercyclical. Inordertotightenmacroprudentialmeasuresintime,policymakersneedsomewarningindicators aboutthevulnerabilityofthesystemandthebuildupofsystemicrisk.Creditandmoneyaggregates mightgiveaglimpseofwhengrowingimbalancesmakethesystemvulnerabletolargewealthshifts triggeredbysmallshocks.Simplylookingatcreditvolumemightbemisleadingbecauseitmayexpand evenastheeconomicsituationdeteriorates.Firmshaveanincentivetodrawonoutstandingcreditlines astheirfinancialoutlookworsens.Excessivedrawdownsoncreditlinesmightbeanearlywarningsign aboutaforthcomingcrisis.Monetaryaggregatesareimportantbecauseshorttermcreditmakesthe bankingsectorespeciallyvulnerable.Asthefundingstructurebecomesmoreshortterm,certaincredit measuresbecomepartofthemonetaryaggregates.Studyingthevolumeofrepofinancing arrangementsmightalsobringoutnewinsightfulconnections(see,e.g.,AdrianandShin(2011)). Moretothepoint,itisimportanttostudytherisktopologyoftheeconomy(seeBrunnermeieretal. (2012)).Howexposedarecertainsectorstofactorshocks?Howlargeistheliquiditymismatchthe differencebetweenmarket/technologicalliquidityontheassetsideandfundingliquidityontheliability side?Theliquiditymismatchprovidesinformationonhowfirmsrespondtoshocksi.e.,whetherthey shedassetsatfiresalepricesorholdontothem.

5. Alternatives: Fiscal and Restructuring Policies

Inadditiontomonetarypolicy,thegovernmentsectorcanalsorespondtoacrisiswithfiscalmeasures oruseamoretargetedrestructuringpolicy.

5.1 Fiscal Stimulus to Boost Aggregate Demand

Koo(2008)andEggertssonandKrugman(2012)arguethatbalancesheetrecessionsarebestdealtwith byincreasinggovernmentexpenditure.Theseauthorstakeissuewiththeclaimthatfiscalstimulus simplyreplaceshouseholdornonfinancialbusinessdebtwithgovernmentdebtandarguethatitmakes adifferencewhoowesthedebt.Koosmainargumentisthatfirmswithimpairedbalancesheetsfocus toomuchonpayingtheirdebtoffandarewillingtoforgomanyprofitableinvestmentopportunities.13 Similarly,householdsdrasticallycutbacktheirconsumption. EggertssonandKrugmanprovideaformalmodelintheNewKeynesiantradition,inwhichprice stickinessandthezerolowerboundonnominalinterestratesplayacentralrole.Formally,themodel considerstwogroupsofhouseholds.Impatienthouseholdsborrowfrompatienthouseholdsuptoan
SimilarlyTobin(1980,p.11)wroteearlierDebtorcorporations,theirequitypositionsimpaired,givepriorityto restorationoffinancialstructureaboverealinvestments.
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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 exogenousdebtlimit.Anunexpecteddropinthedebtlimitrequiresimpatienthouseholdstoscaledown theirconsumptioninordertosatisfythenewlowerdebtlimit.Impatienthouseholdsimmediatesavings effortshavetobemoredrastictheshorterthetransitionperiodis.Anincreaseintheconsumptionof patientagentscanoffsettheimmediatecutbackintheconsumptionofimpatientagents.However,the lesspatientagentswilldosoonlyiftherealinterestratedropsconsiderably,possiblyintonegative territory.Withazerolowerboundfornominalinterestrates,anegativerealinterestratecanbe achievedonlyifexpectedinflationissufficientlyhigh. Assumingthatthecentralbankcannotcommittoahighfuturepricelevel,theonlywaytomakeroom forinflationistodecreasethecurrentpricelevel:deflation.Deflationdoesnotincreasethedebtburden ifdebtisindexed.However,therealvalueofnominaldebtincreases,whichconstrainstheimpatient householdsandlowersthenationalrealinterestratefurther.Theauthorsarguethatincreased governmentspendingwhentheeconomyisagainstthezerolowerboundisafeasiblewayoutofthis dilemma.Thekeyistoreplaceconsumerdemandtemporarilywithgovernmentdemand,whichlowers deflationandhencebenefitsindebtedimpatientconsumers. GuerrieriandLorenzoni(2011)alsostudyadecreaseindebtlimitswithinaBewleystylemodel.A declineinborrowingcapacitymakeshouseholdslessinsuredagainstfutureidiosyncraticshocksand hencetheyincreasetheirlongrunprecautionarysavingsbuffer.Whiledevelopingthisbuffer, householdsconsumptionisdepressedevenfurther. LikeEggertssonandKrugman(2012),severalotherNewKeynesianpapersmakethepointthatthe Keynesianfiscalmultiplierislargewhenthenominalinterestrateisatitszerolowerbound.Thereason isthatanydollarthatis(indirectly)channeledtoconstrainedimpatientconsumersrelaxestheir constraintandallowsthemtoincreasetheirconsumptionsignificantly.Specifically,themarginal propensitytoconsumefortheseconsumersis100%.Eveniftheseagentsdontspendeverydollarright away,thispolicywillatleastshortenthetransitionperiod.

5.2 Restructuring Policies

Therestructuringoftheailingsectorismoretargetedthanthatinducedbyoutrightfiscalexpansion. Suchdebtforgivenesshasalongtradition.InMesopotamia,farmersregularlyendedupoverindebted whenharveststurnedoutworsethanexpected.Toavoidsocialunrest,debtswerewipedoutand farmersgivenafreshstart.Insimilarfashion,inancientGreece,theSolonicreformsof594BCcanceled debtsandoutlawedenslavementfordebtinordertoimprovethesituationofdebtriddenfarmers(see BrunnermeierandOehmke(2012)).IntheU.S.,statewidedebtmoratoriawereintroducedfollowingthe Panicof1819aftercottonfarmerssufferedfromthemorethan50%dropincottonpricesintheperiod fromJanuary1818toJune1819(BoltonandRosenthal2002). Theadvantageofatargetedrestructuringprocessisthatitrequiresclearlossrecognitionand assignment.Thisreducesuncertaintyandasymmetricinformation,butalsorulesoutregulatory forbearance.Theintentofregulatoryforbearanceistogivedebtorstimetoregainsolvency.Arguably, manybankswouldhavealreadybeeninsolventhadtheybeenforcedtowriteofflossesonLatin

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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Americandebtin198283.Ontheotherhand,Japanslostdecadesprovideaclearwarningaboutthe dangersofregulatoryforbearance. Therestructuringtoolkitdependsonwhichsectorsbalancesheetsareimpaired.Ifhouseholdsare overlyindebted,thentargeteddebtforgivenessprogramsarethemainoption.Forthecorporate sectorsassetsales,carveoutsandmergersareimportantrestructuringinstrumentsinadditionto wipingoutexistingshareholdersandvariousbondclaims.Forthefinancialsector,ofteneventhethreat ofinsolvencyissufficienttoinduceaselffulfillingrun.Financialinstitutionsthataresubjecttosucha threatdistorttheirbehaviorwithadverseconsequencesfortherealeconomy.Ifclosetoinsolvency, theymaycutoffcreditflowandinduceacreditcrunch.Iftheyareinsolvent,theymaygamblefor resurrection.Hence,regulatorshavetotakecontrolearlyonthroughpromptcorrectiveactions. AshowcaseofeffectiveinterventionisthatofthegovernmentsintheNordiccountriesin1992.Inone example,theSwedishgovernmentimmediatelysteppedin,tookcontrol,cleanedthebooks, recapitalized,andlaterreprivatizedthefinancialsector.Importantly,toxicassetswerecarvedoutand managedbythebadbanktoensurethattheremaininggoodbankstillhadincentivestograntnew credit,enablingtherealeconomytogrow.14 Anyrestructuringinitiativealsohastoreflectviabilityofthesectorgiventheoverallmarketstructure.If profitmarginsaretoolow(astheyare,forexample,whentheeconomyisoverbanked),more restrictivecleanupoperationsarerequired.

Conclusion
ThetraditionalKeynesianinterestratechannelemphasizestheroleofmonetarypolicyinstimulating aggregatedemandbyinfluencingagentsintertemporaltradeoff.Monetarypolicytriestomitigate effectsfrompricestickiness.Incontrast,thispaperstressestheredistributionalroleofmonetarypolicy analyzedformallyintheITheoryofMoney.Wefocusonfinancialfrictionsanddestabilizing amplificationseffects.Monetarypolicyredistributesnotonlycurrentwealth,butalsoriski.e., contingentfuturewealth.Centralbanksassumptionoftailriskcanreducetheendogenousself generatedriskintheeconomyandincreaseoverallwelfare. Weconcludebysummarizingfirstsomeguidingprinciplesandthensomespecificlessonsaboutthe implementationofmonetarypolicy. First,pricestabilityandfinancialstabilityarecloselyinterlinked.Thisdiscreditstheviewthatmonetary policysprimaryobjectiveispricestabilityandthatfinancialstabilityshouldbeachievedwith independentlyoperatedprudentialinstrumentsandbankingregulation.Monetarypolicyaffectsbalance sheetsthroughassetpricesandflowpaymentsandhencehasdirecteffectsonfinancialstability.

Swedenalsobenefitedfromadepreciationofthecurrencyandsubsequentexportgrowthinatimewhenglobal economywasbooming.
14

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Embargoeduntilpresentationtimeof8:00a.m.MountainDaylightTime,Saturday,September1,2012 Second,policyrulesthatignorefinancialstabilityfailtoleanagainstthebuildupofimbalancesand systemicriskinnormaltimesandarenotcredibleincrisistimes.Onnumerousoccasions,financial turmoilhasforcedcentralbankstointerveneinmarketstostabilizethefinancialsectorwiththe potentialtocompromiselongrunpricestability. Third,unsustainablefiscaldebtlevelscanalsounderminethecredibilityofmonetarypolicyrules.Inthe fiscaldominanceregime,thecentralbankisforcedtochoosebetweeninflationandgovernment default.Apossiblegovernmentdefaulthasadverseknockoneffectsonthefinancialsystemandits stability.Thediabolicloopbetweensovereignriskandbankingriskamplifiestheinitialeffect. Fourth,thetraditionalmonetarytransmissionmechanismisimpairedifnewsaboutpossible governmentdefaultandcreditriskdominatesanyinterestratepolicy. Allfourpointsargueforanintegratedviewofmonetaryandmacroprudentialpolicy(andtosome extentevenfiscalpolicy)measures.Intermsofspecificmonetarypolicyimplications,wedrawthe followinglessons: First,assetholdingsandinterestratesensitivitiesoftheseassetsmatterwhenchoosingbetween conventionalornonconventionalmonetarypolicytools.Forexample,animportantissueiswhether householdshavefloatingmortgagecontractsorarelockedintofixedratemortgages.Achoicetotarget theshortendorlongendoftheyieldcurveshouldalsobeinformedbytheownership,theamount,and thematurityofoutstandinggovernmentdebt.Interestratederivativesexposurescandrasticallyalter themonetarytransmissionchannel. Second,itisnotwisetohavepolicyrulesfornormaltimesthatfocusexclusivelyonpricestabilityand thenhaveadditionalrulesforcrisesstates.Imbalancesandsystemicriskcanbuildupinseeminglyquiet times(volatilityparadox).Importantly,macroprudentialpolicieshavetobemostrestrictiveduringthe runupphaseofboomsandthenrelaxedincrisistimes. Third,rulesshouldconditiononearlywarningindicators,suchasliquiditymismatchesacrossvarious sectorsintheeconomy. Viewingmonetarypolicyasaredistributivetoolopensupawealthofquestions.Forexample, redistributivemonetarypolicyalsohasimportantimplicationsacrossregionsinacurrencyarea.Thisis especiallyimportantintheEuropeancontext.Second,acompleteanalysisshouldalsotakesomeform ofpricerigiditiesintoaccount.Theseandotheraspectsareleftforfutureresearch.

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