CAREER: Economic Crises and Amplification Mechanisms

Project Outcomes Statement

This project has investigated the amplification mechanisms that exacerbate economic crises and the policies that mitigate crises. The project has also spread the academic insights about crises to a broad audience of students and policymakers.

SUMMARY OF RESEARCH

My original plan was to investigate three broad mechanisms that could amplify crises:

1. Liquidity trap --- the lower bound constraint on monetary policy
2. Leverage and its procyclicality
3. Frictions that cause underinsurance in financial markets

My research on the first question showed that asset price fluctuations can induce severe macroeconomic fluctuations when monetary policy is constrained, e.g., due to the liquidity trap. These mechanisms were relevant in both the Great Recession and the Covid-19 recession. The mechanisms motivate unconventional monetary policies such as large-scale asset purchases (LSAPs) and ex-ante policies such as macroprudential regulation.

In "A Risk-Centric Model of Demand Recessions and Speculation," we develop a risk-centric macroeconomic framework that captures the relationship between risky asset prices and aggregate demand. We show that, when monetary policy is constrained, shocks that lower asset prices drag the economy into a demand recession. We also analyze financial speculation, which played a key role in the housing boom before the Great Recession. Speculation during boom periods leads to a larger decline in asset prices in the recession, which exacerbates the recession.

House prices can have a larger impact on spending when households borrow by using their homes as collateral. Then, a decline in house prices can force constrained households to cut their spending to reduce their debt (household deleveraging). Household deleveraging played a major role in the Great Recession. In "Liquidity Trap and Excessive Leverage," we show that the deleveraging mechanism provides a rationale for macroprudential policy during the boom. Left on their own, borrowers take on too much leverage because they do not account for the effect their deleveraging will have on aggregate spending and output --- an effect we refer to as an aggregate demand externality.

House prices affect economic activity also by shaping residential investment. The housing bubble before the Great Recession featured overbuilding of homes, which induced underbuilding during the recession. In "Investment Hangover and the Great Recession," we investigate this overbuilding mechanism and quantify its contribution to the recession.

While the Great Recession was triggered by a collapse of house prices, a decline in stock prices can also reduce household spending through a wealth effect. If monetary policy is constrained, the wealth effect reduces aggregate demand and employment. We provide empirical evidence for this mechanism in "Stock Market Wealth and the Real Economy: A Local Labor Market Approach."

In "A Model of Endogenous Risk Intolerance and LSAPs: Asset Prices and Aggregate Demand in a 'Covid-19' Shock," we apply our risk-centric framework to the recent Covid-19 recession. We find that non-financial productivity shocks (e.g., a Covid-19 shock) can lead to severe contractions in asset valuations and aggregate demand that amplify the recession. We also demonstrate the effectiveness of LSAPs in addressing these contractions.

My research on the second and third research questions evolved into analyzing two mechanisms that can amplify asset price fluctuations: (i) leverage (ii) fickleness of international capital flows.

Leverage is an important amplification mechanism and a major catalyst for speculation. In "Should Retail Investors' Leverage be Limited," we empirically investigate how leverage affects speculation in the retail foreign exchange market. We find that a policy that restricts leverage results in smaller losses for the most aggressive traders without harming market liquidity. The policy also increases belief-neutral welfare and reduces excessive financial intermediation.

In "A Model of Fickle Capital Flows and Retrenchment," we investigate whether international capital flows can cause amplification. In our model, consistent with the data, when a country experiences asset fire sales, foreign investments exit (fickleness), while domestic investments abroad return home (retrenchment). Fickleness amplifies financial distress, but retrenchment mitigates it. We find that when countries have similar returns and financial development, the benefits of retrenchment dominate the costs of fickleness. Fickleness, however, creates a coordination problem because it encourages local policymakers to restrict capital inflows. When countries are asymmetric, capital flows are driven by additional mechanisms, reach-for-safety and reach-for-yield, that can destabilize the receiving country.

SUMMARY OF BROADER OUTREACH

I have engaged in several activities to spread the academic insights about crises and my own research to a broad audience. To highlight a few activities:

- I have co-organized a reading group in macroeconomics and finance for graduate students

- I have designed an undergraduate mini-course, titled "Financial Crises." The materials are publicly available at https://ocw.mit.edu/courses/economics/14-09-financial-crises-january-iap-2016/

- I have written a review paper "The Macroeconomics of Financial Speculation," which covers, among other things, the amplification mechanisms I have studied in this project

- I have written summaries for broader outlets (such as VoxEU), participated in economics podcasts, and talked to journalists to disseminate the research insights from this project.