Financial Integration and Financial Instability Dmitriy Sergeyevy Discussion by Ashoka Mody June 13, 2014, Amsterdam
The Framework • “Entrepreneurs” issue “safe” debt – Valued for liquidity purposes • “Banks” use the proceeds to lend for “risky projects” • Failure of risky projects cause fire sales • …which create negative externalities, which are not internalized
Capital flows can help…but • Periphery benefits from capital inflows — cheaper finance for projects with relatively high marginal products • But some projects will fail, causing negative externalities, which are not accounted for • Periphery regulator can help by taxing bankers who undertake the risky lending • And that is the best outcome • But…
Regulator in the center responds • Periphery tax on bankers: “world” returns on safe debt go down • The Center is “hurt”: lower returns to “entrepreneurs” and more domestic lending with the negative externalities • Center regulator responds by reducing taxes on its bankers to raise “world” returns • In equilibrium, aggregate welfare is lower
Policy Options • Coordination • Capital Controls in the periphery • Reduced reliance on “safe” debt
Policy coordination • Monetary policy analogy • Federal Reserve eases policy to stimulate • Search for yield, capital inflows to emerging economies • Negative externalities: appreciating real exchange rate, higher domestic leverage • Potentially disruptive end — fire sales • “Excess flows”
Coordination in practice • Raghuram Rajan: “[ T]he current environment is one of extreme monetary easing through unconventional policies. To ensure stable and sustainable growth, the international rules of the game need to be revisited.” • Bernanke’s response: “You say that the rules of the game should prevent policies with 'large adverse spillovers ….' If you have a different empirical assessment than I do, that in fact, emerging markets would be better off if they hadn't been used, then you would have a different view."
Capital Controls • Helen Rey, August 2013 – US monetary policy determines global financial cycle – Imposes binding constraint on domestic monetary policy – Independence possible only through capital controls • Klein and Shambaugh, September 2013 – Capital (especially temporary) controls do not work – Even modest exchange rate flexibility helps • Forbes, Fratzscher, Straub, December 2013 – Capital controls do not work on macro targets – But can help reduce financial vulnerability: credit growth, currency mismatches.
“Safe Debt” • The problem is that banks are borrowing “safe short- term” to lend to risky projects • More reliance on equity – Role of exchange rate flexibility • Admati and Hellwig argue for more equity holding by banks • If banks — in the center and the periphery — were required to hold more equity, then would the spillover effects not be mitigated?
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