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Financial Intermediation and Credit Policy in Business Cycle Analysis∗ Mark Gertler and Nobuhiro Kiyotaki N.Y.U. and Princeton October 2009 This version: March 2010 Abstract We develop a canonical framework to think about credit market frictions and aggregate economic activity in the context of the current crisis. We use the framework to address two issues in particular: first, how disruptions in financial intermediation can induce a crisis that affects real activity; and second, how various credit market interventions by the central bank and the Treasury of the type we have seen recently, might work to mitigate the crisis. We make use of earlier literature to develop our framework and characterize how very recent literature is incorporating insights from the crisis. ∗ Prepared for the Handbook of Monetary Economics. Thanks to Michael Woodford, Larry Christiano, Simon Gilchrist, Chris Erceg, and Ian Dew-Becker for helpful comments. Thanks also to Albert Queralto Olive for excellent research assistance. 1 1 Introduction To motivate interest in a paper on financial factors in business fluctuations it use to be necessary to appeal either to the Great Depression or to the experiences of many emerging market economies. This is no longer necessary. Over the past few years the United States and much of the industrialized world have experienced the worst financial crisis of the post-war. The global recession that has followed also appears to have been the most severe of this era. At the time of this writing there is evidence that the financial sector has stabilized and the real economy has stopped contracting and output growth has resumed. The path to full recovery, however, remains highly uncertain. The timing of recent events, though, poses a challenge for writing a Handbook chapter on credit market frictions and aggregate economic activity. It is true that over the last several decades there has been a robust literature in this area. Bernanke, Gertler and Gilchrist (BGG, 1999) surveyed much of the earlier work a decade ago in the Handbook of Macroeconomics. Since the time of that survey, the literature has continued to grow. While much of this work is relevant to the current situation, this literature obviously did not anticipate all the key empirical phenomena that have played out during the current crisis. A new literature that builds on the earlier work is rapidly cropping up to address these issues. Most of these papers, though, are in preliminary working paper form. Our plan in this chapter is to look both forward and backward. We look forward in the sense that we offer a canonical framework to think about credit market frictions and aggregate economic activity in the context of the current crisis. The framework is not meant as comprehensive description of recent events but rather as a first pass at characterizing some of the key aspects and at laying out issues for future research. We look backward by making use of earlier literature to develop the particular framework we offer. In doing so, we address how this literature may be relevant to the new issues that have arisen. We also, as best we can, characterize how very recent literature is incorporating insights from the crisis. From our vantage, there are two broad aspects of the crisis that have not been fully captured in work on financial factors in business cycles. First, by all accounts, the current crisis has featured a significant disruption of financial 2 intermediation.1 Much of the earlier macroeconomics literature with financial frictions emphasized credit market constraints on non-financial borrowers and treated intermediaries largely as a veil (see, e.g. BGG). Second, to combat the crisis, both the monetary and fiscal authorities in many countries including the US. have employed various unconventional policy measures that involve some form of direct lending in credit markets. From the standpoint of the Federal Reserve, these "credit" policies represent a significant break from tradition. In the post war era, the Fed scrupulously avoided any exposure to private sector credit risk. However, in the current crisis the central bank has acted to offset the disruption of intermediation by making imperfectly secured loans to financial institutions and by lending directly to high grade non-financial borrowers. In addition, the fiscal authority acting in conjunction with the central bank injected equity into the major banks with the objective of improving credit flows. Though the issue is not without considerable controversy, many observers argue that these interventions helped stabilized financial markets and, as consequence, helped limit the decline of real activity. Since these policies are relatively new, much of the existing literature is silent about them. With this background in mind, we begin in the next section by developing a baseline model that incorporates financial intermediation into an otherwise frictionless business cycle framework. Our goal is twofold: first to illustrate how disruptions in financial intermediation can induce a crisis that affects real activity; and second, to illustrate how various credit market interventions by the central bank and the Treasury of the type we have seen recently, might work to mitigate the crisis. As in Bernanke and Gertler (1989), Kiyotaki and Moore (1997) and others, we endogenize financial market frictions by introducing an agency problem between borrowers and lenders.2 The agency problem works to introduce a wedge between the cost of external finance and the opportunity cost of in1 For a description of the disruption of financial intermediation during the current recession, see Brunnermeier (2008), Gorton (2008) and Bernanke (2009). For a more general description of financial crisis over the last several hundred years, see Reinhart and Rogoff (2009). 2 A partial of other macro models with financial frictions in this vein includes, Williamson (1987), Kehoe and Livene (1994), Holmstrom and Tirole (1997), Carlstrom and Fuerst (1997), Caballero and Kristhnamurthy (2001), Kristhnamurthy (2003), Christiano, Motto and Rostagno (2005), Lorenzoni (2008), Fostel and Geanakoplos (2009), and Brunnermeir and Sannikov (2009). 3 ternal finance, which adds to the overall cost of credit that a borrower faces. The size of the external finance premium, further, depends on the condition of borrower balance sheets. Roughly speaking, as a borrower’s percentage stake in the outcome of an investment project increases, his or her incentive to deviate from the interests of lenders’ declines. The external finance premium then declines as a result. In general equilibrium, a "financial accelerator" emerges. As balance sheets strengthen with improved economics conditions, the external finance problem declines, which works to enhance borrower spending, thus enhancing the boom. Along the way, there is mutual feedback between the financial and real sectors. In this framework, a crisis is a situation where balance sheets of borrowers deteriorate sharply, possibly associated with a sharp deterioration in asset prices, causing the external finance premium to jump. The impact of the financial distress on the cost of credit then depresses real activity.3 Bernanke and Gertler (1989), Kiyotaki and Moore (1997) and others focus on credit constraints faced by non-financial borrowers.4 As we noted earlier, however, the evidence suggests that disruption of financial intermediation is a key feature of both recent and historical crises. Thus we focus our attention here on financial intermediation. We begin by supposing that financial intermediaries have skills in evaluating and monitoring borrowers, which makes it efficient for credit to flow from lenders to non-financial borrowers through the intermediaries. In particular, we assume that households deposit funds in financial intermediaries that in turn lend funds to non-financial firms. We then introduce an agency problem that potentially constrains the ability of intermediaries to obtain funds from depositors. When the constraint is binding (or there is some chance it may bind), the intermediary’s balance sheet limits its ability to obtain deposits. In this instance, the constraint effectively introduces a wedge between the loan and deposit rates. During a crisis, this spread widens substantially, which in turn sharply raises the cost of credit that non-financial borrowers face. As recent events suggest, however, in a crisis, financial institutions face 3 Most of the models focus on the impact of borrower constraints on producer durable spending. See Monacelli (2009) and Iacoviello (2005) for extensions to consumer durables and housing. Jermann and Quadrini (2009), amongst others, focus on borrowing constraints on employment. 4 An exception is Holmstrom and Tirole (1997). More recent work includes see He and Kristhnamurthy (2009), and Angeloni and Faia (2009). 4 difficulty not only in obtaining depositor funds in retail financial markets but also in obtaining funds from one another in wholesale ("inter-bank") markets. Indeed, the first signals of a crisis are often strains in the interbank market. We capture this phenomenon by subjecting financial institutions to idiosyncratic "liquidity" shocks, which have the effect of creating surplus and deficits of funds across financial institutions. If the interbank market works perfectly, then funds flow smoothly from institutions with surplus funds to those in need. In this case, loan rates are thus equalized across different financial institutions. Aggregate behavior in this instance resembles the case of homogeneous intermediaries. However, to the extent that the agency problem that limits an intermediary’s ability to obtain funds from depositors also limits its ability to obtain funds from other financial institutions and to the extent that nonfinancial firms can obtain funds only from a limited set of financial intermediaries, disruptions of inter-bank markets are possible that can affect real activity. In this instance, intermediaries with deficit funds offer higher loan rates to nonfinancial firms than intermediaries with surplus funds. In a crisis this gap widens. Financial markets effectively become segmented and sclerotic. As we show, the inefficient allocation of funds across intermediaries can further depress aggregate activity. In section 3 we incorporate credit policies within the formal framework. In practice the central bank employed three broad types of policies. The first, which was introduced early in the crisis, was to permit discount window lending to banks secured by private credit. The second, introduced in the wake of the Lehmann default was to lend directly in relatively high grade credit markets, including markets in commercial paper, agency debt and mortgagebacked securities. The third (and most controversial) involved direct assistance to large financial institutions, including the equity injections and debt guarantees under the Troubled Assets Relief Program (TARP) as well as the emergency loans to JP Morgan Chase (who took over Bear Stearns) and AIG. We stress that within our framework, the net benefits from these various credit market interventions are increasing in the severity of the crisis. This helps account for why it makes sense to employ them only in crisis situations. In section 4, we use the model to simulate numerically a crisis that has some key features of the current crisis. Absent credit market frictions, the disturbance initiating the crisis induces only a mild recession. With credit frictions (especially those in interbank market), however, an endogenous disruption of financial intermediation works to magnify the downturn. We then 5 explore how various credit policies can help mitigate the situation. Our baseline model is quite parsimonious and meant mainly to exposit the key issues. In section 5, we discuss a number of questions and possible extensions. In some cases, we discuss a relevant literature, stressing the implications of this literature for going forward. 2 A Canonical Model of Financial Intermediation and Business Fluctuations Overall, the specific business cycle model is a hybrid of Gertler and Karadi’s (2009) framework that allows for financial intermediation and Kiyotaki and Moore’s (2008) framework that allows for liquidity risk. We keep the core macro model simple in order to see clearly the role of intermediation and liquidity. On the other hand, we also allow for some features prevalent in conventional quantitative macro models (such as Christiano, Eichenbaum and Evans (2005), Smets and Wouters (2007)) in order to get rough sense of the importance of the factors we introduce.5 For simplicity we restrict attention to a purely real model and only credit policies, as opposed to conventional monetary models. Extending the model to allow for nominal rigidities is straightforward (see., e.g., Gertler and Karadi, 2009), and permits studying conventional monetary policy along with unconventional policies. However, because much of the insight into how credit market frictions may affect real activity and how various credit policies may work can be obtained from studying a purely real model, we abstract from nominal frictions.6 5 Some recent monetary DSGE models that incorporate financial factors include Christiano, Motto, and Rostagno (2009) and Gilchrist, Ortiz and Zakresjek (2009). 6 There, however, several insights that monetary models add, however. First, if the zero lower bound on the nominal interest is binding, the financial market disruptions will have a larger effect than otherwise. This is because the central bank is not free to further reduce the nominal rate to offset the crisis. Second, to the extent there are nominal price and/or wage rigidities that induce countercyclical markups, the effect of the credit market disruption and aggregate activity is amplified. See, e.g., Gertler and Karadi (2009) and Del Negro, Ferrero, Eggertsson and Kiyotaki (2010) for an illustration of both of these points. 6 2.1 Physical Setup Before describing our economy with financial frictions, we present the physical environment. There are a continuum of firms of mass unity located on a continuum of islands. Each firm produces output using an identical constant returns to scale Cobb-Douglas production function with capital and labor as inputs. Capital is not mobile, but labor is perfectly mobile across firms and islands. Because labor is perfectly mobile, we can express aggregate output Yt as a function of aggregate capital Kt and aggregate labor hours Lt as: , Yt = At Kt α L1−α t 0 < α < 1, (1) where At is aggregate productivity which follows a Markov process. Each period investment opportunities arrive randomly to a fraction π i of islands. On a fraction π n = 1 − π i of islands, there are no investment opportunities. Only firms on islands with investment opportunities can acquire new capital. The arrival of investment opportunities is i.i.d. across time and across islands. The structure of this idiosyncratic risk provides a simple way to introduce liquidity needs by firms, following Kiyotaki and Moore (2008). Let It denote aggregate investment, δ the rate of physical deprecation and ψt+1 a shock to the quality of capital. Then the law of motion for capital is given by : Kt+1 = ψt+1 [It + π i (1 − δ)Kt ] + ψt+1 π n (1 − δ)Kt = ψt+1 [It + (1 − δ)Kt ]. (2) The first term of the right reflects capital accumulated by firms on investing islands and the second is capital that remains on non-investing islands, after depreciation. Summing across islands yields a conventional aggregate relation for the evolution of capital, except for the presence of the disturbance ψt+1 , which we refer to as a capital quality shock. Following the finance literature (e.g., Merton (1973)), we introduce the capital quality shock as a simple way to introduce an exogenous source of variation in the value of capital. As will become clear later, the market price of capital will be endogenous within our framework. In this regard, the capital quality shock will serve as an exogenous trigger of asset price dynamics. The random variable ψt+1 is best thought of as capturing some form of economic obsolescence, as opposed to 7 physical depreciation.7 We assume the capital quality shock ψt+1 also follows a Markov process.8 Firms on investing islands acquire capital from capital goods producers who operate in a national market. There are convex adjustment costs in the gross rate of change in investment for capital goods producers. Aggregate output is divided between household consumption Ct , investment expenditures, and government consumption Gt , Yt = Ct + [1 + f ( It It−1 )]It + Gt (3) It where f ( It−1 )It reflects physical adjustment costs, with f (1) = f 0 (1) = 0 and f 00 (It /It−1 ) > 0. Thus the aggregate production function of capital goods producers is decreasing returns to scale in the short-run and is constant returns to scale in the long-run. Next we turn to preferences: ∙ ¸ ∞ X χ i 1+ε Et (4) β ln(Ct+i − γCt+i−1 ) − L 1 + ε t+i i=0 where Et is the expectation operator conditional on date t information and γ ∈ (0, 1). We abstract from many frictions in the conventional DSGE framework (e.g. nominal price and wage rigidities, variable capital utilization, etc.). However, we allow both habit formation of consumption and adjustment costs of investment because, as the DSGE literature has found, these features are helpful for reasonable quantitative performance and because they can be kept in the model at minimal cost of additional complexity. If there were no financial frictions, the competitive equilibrium would correspond to a solution of the planner’s problem that involves choosing aggregate quantities (Yt , Lt , Ct , It , Kt+1 ) as a function of the aggregate state 7 One way to motivate this disturbance is to assume that final output is a C.E.S. composite of a continuum of intermediate goods that are in turn produced by employing capital and labor in a Cobb-Douglas production technology. Suppose that, once capital is installed, capital is good-specific and that each period a random fraction of goods become obsolete and are replaced by new goods. The capital used to produced the obsolete goods is now worthless and the capital for the new goods is not fully on line. The aggregate capital stock will then evolve according to equation. (2). 8 Other recent papers that make use of this kind of disturbance include, Gertler and Karadi (2009), Brunnermeier and Sannikov (2009) and Gourio (2009). 8 (Ct−1 , It−1 , Kt , At , ψ t ) in order to maximize the expected discounted utility of the representative household subject to the resource constraints. This frictionless economy (a standard real business cycle model) will serve as a benchmark to which we may compare the implications of the financial frictions. In what follows we will introduce banks that intermediate funds between households and non-financial firms in a retail financial market. In addition, we will allow for a wholesale inter-bank market, where banks with surplus funds on non-investment islands lend to banks in need of funds on investing islands. We will also introduce financial frictions that may impede credit flows in both the retail and wholesale financial markets and then study the consequences for real activity. 2.2 Households In our economy with credit frictions, households lend to non-financial firms via financial intermediaries. Following Gertler and Karadi (2009), we formulate the household sector in way that permits maintaining the tractability of the representative agent approach. In particular, there is a representative household with a continuum of members of measure unity. Within the household there are 1 − f "workers" and f "bankers". Workers supply labor and return their wages to the household. Each banker manages a financial intermediary (which we will call a "bank") and transfers nonnegative dividends back to household subject to its flow of fund constraint. Within the family there is perfect consumption insurance. Households do not hold capital directly. Rather, they deposit funds in banks. (It may be best to think of them as depositing funds in banks other than the ones they own). In our model, bank deposits are riskless one period securities. Households may also hold riskless one period government debt which is a perfect substitute for bank deposits. Let Wt denote the wage rate, Tt lump sum taxes, Rt the gross return on riskless debt from t − 1 to t, Dht the quantity of riskless debt held, and Πt net distributions from ownership of both banks and non-financial firms. Then the household chooses consumption, labor supply and riskless debt (Ct , Lt , Dht+1 ) to maximize expected discounted utility (4) subject to the flow of funds constraint, 9 Ct = Wt Lt + Πt − Tt + Rt Dht − Dht+1 . (5) Let uCt denote the marginal utility of consumption and Λt,t+1 the household’s stochastic discount factor. Then the household’s first order conditions for labor supply and consumption/saving are given by Et uCt Wt = χLϕt , (6) Et Λt,t+1 Rt+1 = 1, (7) with uCt ≡ (Ct − γCt−1 )−1 − βγ(Ct+1 − γCt )−1 and uCt+1 . uCt Because banks may be financially constrained, bankers will retain earnings to accumulate assets. Absent some motive for paying dividends, they may find it optimal to accumulate to the point where the financial constraint they face is no longer binding. In order to limit bankers’ ability to save to overcome financial constraints, we allow for turnover between bankers and workers. In particular, we assume that with i.i.d. probability 1 − σ, a banker 1 exits next period, (which gives an average survival time = 1−σ ). Upon exiting, a banker transfers retained earnings to the household and becomes a worker. Note that the expected survival time may be quite long (in our baseline calibration it is ten years.) It is critical, however, that the expected horizon is finite, in order to motivate payouts while the financial constraints are still binding. Each period, (1 − σ)f workers randomly become bankers, keeping the number in each occupation constant. Finally, because in equilibrium bankers will not be able to operate without any financial resources, each new banker receives a "start up" transfer from the family as a small constant fraction of the total assets of entrepreneurs. Accordingly, Πt is net funds transferred to the household:i.e., funds transferred from exiting bankers minus the funds transferred to new bankers (aside from small profits of capital producers). An alternative to our approach of having a consolidated family of workers and bankers would be to have the two groups as distinct sets of agents, without any consumption insurance between the two groups. It is unlikely, however, that the key results of our paper would change qualitatively. By Λt,t+1 ≡ β 10