F33 | Macro Paper Warehouse

A Model of Safe Asset Determination

This paper asks what makes a government bond a “safe asset” and answers that safety is to a large degree a coordination outcome rather than a property of the income stream standing behind the bond. In a two-period model, two countries – a large one whose debt is normalized to size one and a small one of size s in (0,1] – each auction zero-coupon bonds to a continuum of risk-neutral investors who have savings of 1+f to place and, in the baseline, nowhere else to put them. A country defaults precisely when its fiscal surplus plus its bond proceeds fall short of the debt coming due, so an investor’s payoff depends on how many other investors buy the same bond: below a participation threshold the bond is worthless, which makes investor actions strategic complements, and above it extra demand simply bids the fixed supply of bonds up and returns down, which makes them strategic substitutes. Using global-games techniques – a publicly observed world fundamental, an unobserved relative-strength variable, and private signals whose noise vanishes – the authors solve for a unique threshold in the monotone strategy space and obtain a closed form in which the large country’s advantage is a market-depth term scaled by aggregate funding conditions and its disadvantage is a rollover-risk term. Three implications follow. First, relative rather than absolute fundamentals determine safety, which is why US Treasuries and the German Bund can retain and even strengthen their safe-asset status while their own fiscal positions deteriorate, since everyone else’s deteriorated too. Second, debt size helps or hurts depending on the aggregate funding condition: when world savings are abundant a large float is the best parking spot and is safer, but when savings are scarce investors fear that the large issue will not attract enough demand and coordinate instead on the smaller issuer – possibly one with worse fundamentals. Third, once positive recovery in default is allowed, cash-in-the-market pricing makes the safe bond a negative-beta asset whose price rises as aggregate fundamentals worsen, and the beta becomes more negative the stronger the safe country’s relative position. The authors then use the model normatively. For Eurobonds, with a share alpha of debt issued as a common bond, welfare gains in the form of greater safety for both countries arrive only once alpha exceeds a threshold; below it, in the equilibrium where only one country is safe, raising alpha can make the small country less safe, because it captures proportionally little of the common-bond proceeds – so “small steps towards a fiscal union could be worse than no step.” Endogenizing debt size, the competition for safe-asset status has a tournament structure: when natural sizes are similar and aggregate funding is strong both countries expand beyond their natural sizes in a self-defeating rat race that the model links to the pre-crisis expansion of US agency debt and of euro-area sovereign debt, while sufficiently asymmetric sizes produce a “top dog” who contracts and a challenger who expands. The results are derived in a deliberately stylized setting – two periods, two countries, risk-neutral investors placing price-independent market orders, no alternative storage technology in the baseline, and the vanishing-noise limit – and the authors present their historical and crisis applications as interpretations the model can rationalize rather than as estimated effects.

Capital flows and the risk-taking channel of monetary policy

Bank leverage is the linchpin of a risk-taking channel through which monetary policy travels across borders: in a pre-crisis quarterly VAR a tighter US policy rate raises the VIX, lowers broker-dealer leverage, appreciates the dollar and shrinks cross-border bank flows, and an accompanying contracting model delivers the result that bank leverage rises with the expected appreciation of the borrower’s currency. The empirical work is a recursive VAR on quarterly data from 1995Q4 to 2007Q4 in the real fed funds target rate, the log VIX, the leverage of the US broker-dealer sector from the Flow of Funds, and the log change in the dollar’s real effective exchange rate, estimated with two lags and 90 percent bootstrapped confidence bands from 1,000 replications. Three links appear. A positive fed funds shock raises the VIX from quarter 4, consistent with Bekaert, Hoerova and Lo Duca’s finding of an effect between months 9 and 11. A rise in the VIX lowers broker-dealer leverage. And a positive fed funds shock lowers leverage after a lag of around 10 quarters, remaining significant to quarter 17, with a maximum response of minus 0.47 at quarter 12 – against a sample average leverage of 21.94, a decline to about 21.5. Leverage in turn moves the exchange rate: an increase in broker-dealer leverage lowers the dollar’s real effective exchange rate by 0.42 percent by quarter 3, with an effect that stays significantly negative across the whole 20-quarter horizon, which the paper offers as a complement to the delayed overshooting puzzle of Eichenbaum and Evans (1995). Adding the first difference of the BIS series for dollar liabilities of banks outside the US shows that higher broker-dealer leverage raises cross-border bank flows after 11 quarters, peaking at 17, and that a fed funds tightening lowers those flows from quarter 8 to quarter 17. Variance decompositions show monetary policy shocks accounting for almost 30 percent of VIX variance and 10 to 20 percent of leverage variance beyond 10 quarters, while leverage shocks account for over 20 percent of exchange rate variance and almost 40 percent of fed funds variance. The theory then rationalises this with a contracting problem in which a bank funds dollar loans from the wholesale market and its local borrowers hold local-currency assets: moral hazard over the correlation of the loan portfolio yields a unique solution with a binding leverage constraint, zero bank default, and the paper’s main proposition that leverage is increasing in expected currency appreciation. Two scope conditions are load-bearing and the authors state both. The sample stops in 2007 because extending it through the zero lower bound produces “markedly weaker VAR impulse responses,” with many fed funds responses insignificant, so “the results reported in this paper should be seen as applying mainly for the boom period preceding the onset of the crisis.” And the amplification story relies on capital inflows coinciding with appreciation, which conflicts with uncovered interest parity; the paper notes UIP’s empirical failure but says plainly that “uncovering the precise mechanism for the failure of UIP is beyond the scope of our paper.”

Dollarization in Argentina

Written shortly after Argentina’s government publicly floated the idea of abandoning the peso for the U.S. dollar, this Chicago Fed piece uses Argentina’s 1991-99 currency-board experience – already “quite close to being fully dollarized” – as a test case for the broader debate over monetary anchors: fixed versus flexible exchange rates internationally, and rules versus discretion domestically, of which “dollarization is the ultimate rule.” The authors first document how the 1991 convertibility law ended Argentina’s chronic hyperinflation (78 percent per month at its worst) by pegging the peso to the dollar under a currency board requiring the central bank to hold reserves equal to at least 100 percent of the monetary base, and how this stabilization coincided with faster growth, though the peg has twice come under speculative pressure – the 1995 “Tequila” crisis following Mexico’s devaluation, and the 1998-99 “Vodka-Caipirinha” turmoil following Russia’s default and Brazil’s devaluation. They then work through the mechanics of unilateral and bilateral dollarization, calculating that Argentina would permanently forgo seigniorage income worth roughly 0.2 percent of GDP annually – income that would instead accrue to the United States – while gaining a stronger commitment device than a currency board, since a currency board still leaves scope for a government to reintroduce discretion (via emergency decree or a change in law) that a full currency abolition would foreclose. The paper argues most of the commonly raised objections to dollarization – loss of a lender of last resort, loss of monetary policy independence – are less decisive than they first appear, given mechanisms Argentina has already built to substitute for both, and it closes with a rough cost-benefit calculation suggesting dollarization would be worthwhile if crises resembling the Tequila effect (a roughly 14 percent permanent output loss) recur with even modest probability. The authors are explicit, however, that they “do not reach a definite answer on whether Argentina should dollarize,” and caution that abandoning even the possibility of an independent monetary policy is a serious and irreversible step.

Fiscal Imbalances and the Dynamics of Currency Crises

This paper builds a model in which a currency crisis is triggered by a “fiscal imbalance” – a current or anticipated future decline in the present value of the government’s real primary surpluses – and studies how the size and maturity structure of the government’s outstanding nominal liabilities, rather than the size of the fiscal gap alone, determine whether and for how long a fixed exchange rate can be defended before it collapses. In a baseline economy where the government holds only short-term nominal debt, the authors derive a “razor-edge” result: if the government tries to delay a devaluation to raise seigniorage revenue after the collapse, the present value of that seigniorage exactly offsets the fiscal cost of defending the peg beforehand (the revenue lost to the pre-collapse contraction in money demand), leaving the net present value of seigniorage equal to zero – so financing a fiscal imbalance through money creation and delaying the exchange-rate adjustment turn out to be mutually inconsistent goals, and with only short-term debt outstanding the peg must break immediately, with the size of the initial devaluation pinned down by the fiscal imbalance and the stock of outstanding money and bonds. Once the model is extended to include long-term, non-indexed government bonds (perpetuities), a different channel opens: news of a future fiscal imbalance causes an immediate, unanticipated fall in the price of those bonds, transferring wealth from private bondholders to the government exactly as an unexpected devaluation would, which can let the government postpone the collapse of the peg for a time even when the net present value of seigniorage is zero, provided the outstanding stock of long-term liabilities is large enough. Government solvency alone leaves the exact date of a delayed collapse indeterminate within a finite window; adding a monetary policy rule under which the central bank defends the peg only as long as the domestic interest rate stays below some threshold pins the timing down uniquely, via a backward-induction argument analogous to Krugman’s (1979) classic model but expressed in terms of an interest-rate rather than a reserve-based defense criterion. The paper also shows that when investors can trigger a self-fulfilling run on the government’s short-term debt – a coordination failure distinct from the fiscal mechanism – the exact timing of collapse becomes genuinely indeterminate and unpredictable even though the underlying fiscal imbalance still bounds how long the peg can possibly survive. Framed explicitly as an extension of the fiscal theory of the price level to a currency-crisis setting, and as a bridge to first-generation, Krugman-style crisis models, the paper’s authors are careful to note that a precisely zero net seigniorage result is a feature of their specific model, but argue the underlying lesson – that the fiscal costs of peg defense constrain what seigniorage policy can actually achieve – is more general.

Globalization and Capital Markets

Written as the financial-globalization backlash of the late 1990s was at its height, this chapter asks whether the integration of world capital markets at the turn of the twenty-first century was unprecedented, and what governed its rise and fall. The received narrative is a U – high mobility under the classical gold standard, destruction between 1914 and 1945, slow reconstruction under Bretton Woods, and a renewed rise after the early 1970s – and the authors are explicit that this is a hypothesis to be tested rather than a result, labelling their own stylised figure of it “Conjecture?” with the source listed as “Introspection.” The explanation they propose is the open-economy policy trilemma: since a government can have at most two of free capital movement, a fixed exchange rate, and a monetary policy oriented to domestic goals, capital mobility survived wherever politics supported one of the corner solutions and was suppressed wherever governments tried to occupy the middle ground. Because no single measure of market integration is decisive – price convergence and flow volumes both fail as criteria, and “all such tests may be able to evaluate market integration, but only as a joint hypothesis test where some auxiliary assumptions are needed” – the paper runs a battery. On quantities, foreign assets were about 7 percent of world GDP in 1870, just under 20 percent at the 1900-14 zenith of the gold standard, 8 percent in 1930, 11 percent in 1938, 5 percent in 1945, 6 percent in 1960, 25 percent in 1980 and 62 percent in 1995 – so “the 1900-14 ratio of foreign investment to output in the world economy was not equaled again until 1980, but has now been approximately doubled,” with liabilities tracing the same path (21 percent in 1914, 11 percent in 1938, 2 percent in 1960, 30 percent in 1980, 79 percent in 1995). Measured against the GDP only of countries with data, however, the seven great creditors exceeded 50 percent from 1870 to 1914, a level “we only surpassed … as recently as 1990, and only narrowly even then.” On prices, long-term real interest differentials against the United States for Britain, France and Germany are stationary over the whole 1890-2000 span and in most subperiods, with the unit-root null rejected at 1 percent almost everywhere except the recent float; covered and quasi-covered nominal differentials since 1870 widen in exactly the periods the U predicts, and threshold estimates of the no-arbitrage band – roughly 19 basis points for New York-London and 35 for London-Berlin before 1914, against 60 and 91 in the interwar years and about 6 in the mid-1980s – put pre-1914 integration “truly impressive compared to conditions over the following half-century or more.” Cross-country dispersion of dollar equity returns follows the same U for the G7. The authors then argue that only policy can account for the mid-century collapse, since “technology is a poor candidate” – financial techniques were not forgotten in the 1930s, and some, such as foreign exchange futures, matured then. The political-economy section supplies supporting evidence from bond spreads: on a consistent 1870-1940 London panel, being on gold lowered spreads by about 57 basis points before 1914 and only peripheral countries were punished for public debt (7.2 basis points per 10 percentage points of debt to GDP), whereas for 1925-30 the gold dummy is insignificant or wrongly signed, core and periphery are no longer distinguished, debt sensitivity is roughly five times larger, and estimated reputational persistence falls from 0.68 to 0.30. Finally the paper insists on one large difference between the two globalizations. Pre-1914 flows were long-term and nearly one-way, so gross and net positions nearly coincided; today the same rich countries top both the asset and liability rankings, net positions have stayed very low since 1980, and the developing-country share of global liabilities has fallen from 33 percent in 1900 to 11 percent in the 1990s. Today’s integration is therefore “mostly a rich-rich affair, a process of ‘diversification finance’ rather than ‘development finance’,” and the Lucas paradox of capital failing to reach capital-poor countries is, if anything, sharper now than a century ago.

U.S. Monetary Policy and the Global Financial Cycle

A single global factor extracted from a large panel of risky asset prices traded around the world falls sharply after a US monetary contraction, alongside deleveraging by global banks, a rise in aggregate risk aversion, contracting credit provision and retrenching international credit flows – and countries with floating exchange rates are subject to financial spillovers of similar magnitude. The paper proceeds in two empirical steps plus a model. First, a dynamic factor model fitted to 858 monthly price series for 1990-2012 – equities from North America, Latin America, Europe, Asia Pacific and Australia, corporate bond indices, and commodities excluding precious metals – supports a unique common global factor that accounts for over 20 percent of the common variation; on a narrower 303-series panel covering only the US, Europe, Japan and commodities but reaching back to 1975, one factor accounts for about 60 percent. Second, monthly Bayesian VARs with 12 lags estimated over 1980-2010 – a 13-variable closed-economy version and 15-variable global versions – are identified with an external instrument built from 30-minute price revisions in the fourth federal funds futures contract around FOMC announcements. For a shock normalised to raise the one-year Treasury rate by 1 percent on impact, the domestic responses are conventional: production, capacity utilisation and housing starts fall, unemployment rises, prices decline without a price puzzle, the excess bond premium and mortgage spreads widen, house prices and the S&P 500 fall, and the dollar appreciates. The global responses are the paper’s point. The global factor drops about 40 percent on impact, which the authors translate – under the explicit assumption that all asset prices load equally on the factor – into roughly an 8 percent fall in a local stock market, a figure consistent with the estimated US, UK and euro-area equity responses. Measured aggregate risk aversion rises by over 50 percent above its average trend. Global domestic credit and cross-border credit inflows to both banks and non-banks contract by several percentage points, with global real activity outside the US left unchanged on impact as a control, and the credit contraction is not driven by the US component. Leverage falls strongly and quickly for US security brokers and dealers and for European global systemically important banks, while broader banking aggregates react later and more weakly – no appreciable change for US banks and a European trough about a year out. Restricting the global aggregates to the 32 countries the IMF classified as independently floating leaves the credit and inflow contractions “very similar to that obtained over the full sample.” For the UK and euro area specifically, equity indices plummet, the dollar appreciates in a reversal-prone way over one to four quarters, corporate spreads widen on impact, and policy rates ease endogenously by about 30 basis points – so the local tightening of financial conditions “cannot be ascribed to a domestic monetary policy tightening.” The authors state the interpretive limit carefully: the floater result “challenges the degree of monetary policy sovereignty of open economies” and echoes Rey’s (2013) trilemma-to-dilemma claim, but “does not mean that exchange rate regimes do not matter,” and whether open-economy models with Value-at-Risk-type frictions can actually reproduce these regularities “still remains to be seen.”