Hot Money and Serial Financial Crises Anton Korinek University of Maryland

Eleventh Jacques Polak Annual Research Conference on “Macroeconomic and Financial Policies after the Crisis” IMF Research Department November 4 - 5th, 2010

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Motivation

Motivation: World economy has experienced serial financial crises linked by a recurrent pattern: one country (sector) experiences crisis hot money flows out in panic global investors seek next attractive destination create boom in asset prices and debt followed by next crisis

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Motivation

Dual Interpretation: Let’s look at prices (world interest rate) rather than quantities (capital flows): financial turmoil in one area depresses borrowing capacity and world demand for capital → lower world interest rate → increased incentive to leverage for other countries → higher financial fragility for rest of world economy

potential for “serial financial crises” increased role for macro-prudential policies when parts of world economy financially constrained

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Interest Rates and Capital Flow Bonanzas 6%

50% US 10y (real) % Bonanzas

5%

45% 40% 35%

4%

30% 3%

25% 20%

2%

15% 10%

1%

5% 0% 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

0%

Figure: IMF IFS and Reinhart & Reinhart (2008)

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Capital Flow Bonanzas and Crises 45% 40%

% Bonanzas (3y MA, Lag 3)

35%

% Banking crises (3y MA)

30% 25% 20% 15% 10% 5% 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

0%

Figure: IMF IFS and Reinhart & Reinhart (2008)

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Key Assumptions International financial markets are imperfect: global investors seek opportunities to invest (lend) but borrowing by countries is subject to financial constraints constraints depend on collateral (asset prices, exchange rates) potential feedback spirals: collapsing collateral prices tightening borrowing constraints declining demand

→ financial amplification, financial crises, debt deflation, ...

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Feedback Spirals Economic shock Falling Spending Tightening Constraint

Adverse Movement in Relative Prices

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Feedback Spirals Economic shock Falling Spending Tightening Constraint

Adverse Movement in Relative Prices

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Key Results shortage of global investment opportunities pushes countries to borrow close to the limit negative shocks cause financial feedback loops (crises) feedback loops entail externalities → rationale for macro-prudential regulation of capital flows crises in one country push capital into other countries → hot money → even greater externalities → increased importance of capital flow regulation

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Relationship to Literature

Financial amplification: Fisher (1933), Bernanke-Gertler (1989), Kiyotaki-Moore (1997), Mendoza (2002), etc. Pecuniary externalities: Hart (1975), Stiglitz (1982), Caballero-Krishnamurthy (2003), Korinek (2007, 2009), Lorenzoni (2008), Jeanne and Korinek (2010), etc. Multi-Country Transmission of Financial Shocks: Aoki et al. (2008), Caballero et al. (2008ab), Devereux and Yetman (2010), Nguyen (2010), etc.

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Model Structure

Infinite time: t = 0, 1, ... Global financial markets: trade bonds only Global investors h: hold bonds bh Two regions with a unit mass of countries: North N and South S hold bonds bN and bS Market clearing: bth + btN + btS = 0 ∀t

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Model Structure: Global Investors Global investors: OLG structure live for two periods and earn endowments e1 , e2 enjoy consumption according to h U = log(cth ) + βlog(ct+1 ) h : smooth endowment income by saving bt+1 h cth = e1 − bt+1 /Rt+1 ,

h h ct+1 = e2 + bt+1

supply of funds: R(bh ) =

(1 + β)bh + e2 = R(−bN − bS ) βe1

→ interest rate R rises in the amount countries borrow Anton Korinek (2010)

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Model Structure: Countries Country i inhabited by representative agent (Jeanne-Korinek ’10) Obtain income yti from a tree in country i every period Trees can be traded, but only within the country Hold bonds bti with outsiders max Uti = Et

∞ X

! β s−t u(csi )

s=t i s.t. csi + as+1 ps +

i bs+1 = asi (psi + ysi ) + bsi R

borrowing is limited by a moral hazard problem i bs+1 ≥ −φpsi Rs+1

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Deterministic One Country Case Two possible equilibria: 1

Unconstrained equilibrium if borrowing capacity φ is sufficiently high for global investors to smooth their income: unc bSS =

e1 − e2 ≤ φpSS 1+β

→ sufficient investment opportunities → world interest rate satisfies βR = 1 2

unc > φp Constrained equilibrium if bSS SS

lack of sufficient investment opportunities → world interest rate satisfies βR < 1 → world economy inherently unstable; potential for persistent economic fluctuations

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Dynamics b’

45°

b’

45°

constrained

unconstrained

b

b

R

R

RSS

bSS

b

bSS

b

Figure: Unconstrained and constrained dynamics Anton Korinek (2010)

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Constrained Planner

Policymaker (Constrained Planner) in small open economy: coordinates borrowing choices in the economy by imposing regulation on capital inflows internalizes effects of feedback spirals (deleveraging depresses asset prices and borrowing capacity) lets asset prices be determined by free market takes global interest rates as given

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Constrained Planner Euler equation in free market equilibrium: h i i u 0 (cti ) = λit + βREt u 0 (ct+1 ) Euler equation in planner’s equilibrium: " u

0

(cti )

=

λit

+ βREt u

0

i (ct+1 )

+

λit+1 φ

i ∂pt+1

#

i ∂bt+1

∂pi

Interpretation of externality kernel λit+1 φ ∂bt+1 : i t+1

i ∂pt+1 i ∂bt+1

captures asset price increase resulting from higher wealth

φ reflects resulting relaxation in borrowing constraint λit+1 represents utility cost of constraint Anton Korinek (2010)

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Constrained Planner Externality arises if borrowing constraint binding next period → planner takes on less debt → less severe future constraints, → less volatility and financial fragility Implementation of Optimal Regulation: Introduce tax on collateralized borrowing: " # i i   βRλ ∂p t+1 τ ∗ bti , yti = Et · φ t+1 i u 0 (cti ) ∂bt+1 (note: opposite of interest deductability on debt!) Macro-prudential regulation in bank-based system Anton Korinek (2010)

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Calibration

Assumptions: time period = 3 years output yti ∈ {y L , y H } binomial (boom/bust) and i.i.d. probability of low output is π = 10% unc = 1.05 · φp set global investors’ desire to save so that bSS SS

β 0.963

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Parameter Values γ φ yH yL 2 0.05 1 0.97

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Model Dynamics Model dynamics: Persistent motive to borrow because of asset shortage (βR < 1) In booms asset price is high → high borrowing capacity → economies accumulate debt → global investors can lend more In busts, there is deleveraging and asset price deflation → economies need to cut back on borrowing → global investors have few lending opportunities → global interest rates decline Low global interest rates increase incentive to take on debt for unconstrained economies → greater vulnerability to future busts → potential for serial financial crises Anton Korinek (2010)

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N

y

1

N

c

0.8 0

5

10

15

20

25 yS

1

cS

0.8 0 −0.3 −0.4 −0.5 −0.3 −0.4 −0.5 4% 2% 0% 4% 2% 0% 4% 2% 0%

5

10

15

20

25

w’N 0

5

10

15

20

25

w’S 0

5

10

15

20

25 R

0

5

10

15

20

25

0

5

10

15

20

25

0

5

10

15

20

25

τN

τS T

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Neo-Mercantilism

Neo-mercantilism (reserve accumulation): increases global supply of capital → exacerbates shortage of investment opportunities → pushes down world interest rate → increases global financial fragility → reinforces need for capital flow regulation

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Strategic Complementarities of Regulation

Regulation of capital inflows in some countries increases supply of capital to other countries → exacerbates externalities in other countries → reinforces incentives for other countries to regulate → strategic complementarity

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Investment and Growth

In our simple model of an endowment economy: binding constraints depress consumption, credit, asset prices In practice: binding constraints also depress investment, growth → increased welfare costs of financial crises → increased importance of regulating capital flows

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Conclusions

Global financial system with collateralized borrowing is inherently unstable Private borrowers take on excessive debt Crises in one region push hot money into other regions → externalities of capital inflows particularly large → greater importance of capital flow regulation

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