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Story - antoq - 10/04/2010 - 01:50 - 0 comments - 0 attachments
Liberalization and integration of financial markets have been associated with an increase in capital movements and with financial crises. In particular, surges in foreign short-term debt have been blamed for crisis episodes in emerging economies in Asia (Thailand, Indonesia and South Korea) and Latin America (Mexico, Brazil, Ecuador and Argentina), as well as in the periphery of Europe (Turkey). These crises have proved costly in terms of output.
Several policy responses have been suggested. Among them, reduction of short term-debt levels, stock-market development, improved regulation and supervision of the domestic financial system, enhanced transparency requirements and market discipline, as well as the establishment of an international lender of last resort (LOLR). A catalog of “solutions” has been proposed to take care of the problems of banking in emerging economies, including moving to a narrow banking system, building a currency union, and leaving banking in the hands of foreign banks and offshore institutions.
Real business cycle theory develops the idea that business cycles can be generated by random fluctuations in productivity. At the core of this research program, the fundamental issues are how individuals react to productivity shocks and how these reactions affect the macro economy. While the issue of reaction to shocks is typically studied at the individual level, it can also be raised at the societal level. How do individuals, through their political institutions, collectively decide to adjust fiscal policies in response to changes in productivity? Moreover, what is the role of changes in fiscal policy in amplifying or dampening shocks? Though understanding individual responses to shocks can be addressed with the tools of basic microeconomics, understanding societal responses requires a study of how collective choices are made in complex dynamic environments.
In the last two decades, political economy has made important progress, both theoretically and empirically, in understanding how governments function and the type of distortions that the political process generates in an economy. This first generation of research, however, has largely focused on static or two period models that are not well suited to answer the questions raised by real business cycle theory. When longer time horizons are considered, other important elements of the environment (such as shocks, rational forward looking agents, etc) are muted. Thus, the basic question as to how governments react to business cycles is not well understood. Because of this, empirical analysis on the cyclical behavior of fiscal policy remains largely guided by normative models of policy making.
Bryant (1980) and Diamond and Dybvig (1983) have provided us with the classic benchmark model for a bank run. There, an individual bank engages in maturity transformation, using demand deposits to finance long term loans, which can be liquidated in the short term only at a cost. If too many agents claim short-term liquidity needs and withdraw their demand deposits, the value of the bank assets are thus not sufficient to meet these liquidity demands, in turn justifying even patient depositors to get their money while they can: a bank run ensues. One policy conclusion then is for a central bank to follow the classic Bagehot principle of committing to inject liquidity to illiquid but otherwise solvent bank, in order to stop bank runs.
The financial crisis of 2007 and 2008 is reminiscent of a bank run, but not quite, see Brunnermeier (2008). First, this was (with few exceptions) not a run of depositors on their local house bank, but a run of banks and money funds on some core financial institutions. Second, the health of some core financial institutions (I shall call them “core banks” for the purpose of this paper) was called into question not because of their commitment to costly- to-call long-term loans, but rather because of the questionable value of a variety of “exotic” securities, most notably their guarantees for particular tranches of mortgage-backed security derivatives and credit default swaps. These are assets which could be marked to market at least in principle. So, when a bank cannot repay its depositors because the market value of their assets is below the value of its liabilities, the traditional prescription is to declare the bank to be bankrupt and not to provide it with additional liquidity.
