When investors are unwilling to hold the economy's risk, a decline in the interest rate increases the Sharpe ratio of the market and equilibrates the risk markets. If the interest rate is constrained from below, risk markets are instead equilibrated via a decline in asset prices. However, the latter drags down aggregate demand, which further drags prices down, and so on. If investors are pessimistic about the recovery, the economy becomes highly susceptible to downward spirals due to dynamic feedbacks between asset prices, aggregate demand, and growth. In this context, belief disagreements generate highly destabilizing speculation that motivates macroprudential policy.
Does the provision of leverage to retail traders improve market quality or facilitate socially inefficient speculation that enriches financial intermediaries? This paper evaluates the effects of 2010 regulations that cap the provision of leverage to previously unregulated U.S. retail traders of foreign exchange. Using three unique data sets and a difference-in-differences approach, we document that the leverage constraint reduces trading volume by 23 percent, improves high-leverage traders' portfolio return by 18 percentage points per month (thereby alleviating their losses by 40 percent), and reduces brokerages' operating capital by 25 percent. Yet, the policy does not affect the relative bid-ask prices charged by the brokerages. The announcement of pending leverage restrictions has no effect on the traders or the market. We reconcile these findings with a model in which traders with heterogeneous and dogmatic beliefs take speculative positions in pursuit of high returns, and a competitive brokerage sector intermediates these trades subject to technological and informational costs. The model is largely consistent with our empirical findings, and it suggests that the leverage constraint policy generates a sizable belief-neutral improvement in social welfare by economizing on the productive resources used to intermediate speculation.
In Caballero and Simsek (2017), we develop a model of fickle capital flows and show that, when countries are similar, international flows create global liquidity and mitigate crises despite their fickleness. In this paper, we focus on the asymmetric situation of Emerging Markets (EM) exchanging flows with Developed Markets (DM) that feature lower returns but less frequent crises. Relatively high DM returns help to mitigate EM crises, by reducing fickle inflows, and by providing greater liquidity. The situation dramatically changes as the DM returns fall, as this increases the fickle inflows driven by reach for yield and exacerbates EM crises.
Caballero, R. and A. Simsek (2017), "A Model of Fickle Capital Flows and Retrenchment"
We develop a global equilibrium model of capital flows that addresses the tension between their fickleness during foreign crises and retrenchment during local crises. In a symmetric world with a scarcity of safe assets, gross flows mitigate crises since the fickle flows exit the country at weak prices (or exchange rates) whereas retrenched flows are brought back at relatively high valuations. However, the fickleness of flows is not inconsequential as it induces local policymakers to tax capital flows despite their global liquidity provision benefits. If the system is heterogeneous, the model features reach-for-safety and reach-for-yield flows that can destabilize developed and emerging market economies, respectively.
Iachan, F., P. Nenov, and A. Simsek (2017), "The Choice Channel of Financial Innovation"
Financial innovations in recent decades have expanded portfolio choice. We investigate how greater choice affects investors' savings. We establish a choice channel by which greater portfolio choice increases investors' (nonprecautionary) savings---by enabling them to earn the aggregate risk premium or to take speculative positions. We provide empirical evidence for this channel by examining the saving behavior of U.S. households since the 1980s. We also theoretically analyze the effect of choice on asset returns. Portfolio customization (access to risky assets other than the market portfolio) reduces the risk-free rate, whereas participation reduces the risk premium but typically increases the risk-free rate.
We propose a tractable model of bargaining with optimism. The distinguishing feature of our model is that the bargaining power is durable and changes only due to important events such as elections. Players know their current bargaining powers, but they can be optimistic that events will shift the bargaining power in their favor. We define congruence (in political negotiations, political capital) as the extent to which a party's current bargaining power translates into its expected payoff from bargaining. We show that durability increases congruence and plays a central role in understanding bargaining delays, as well as the finer bargaining details in political negotiations. Optimistic players delay the agreement if durability is expected to increase in the future. The applications of this durability effect include deadline and election effects, by which upcoming deadlines or elections lead to ex-ante gridlock. In political negotiations, political capital is highest in the immediate aftermath of the election, but it decreases as the next election approaches.
Acemoglu, D. and A. Simsek (2012), "Moral Hazard and Efficiency in General Equilibrium with Anonymous Trading," working paper [slides]
A "folk theorem" maintains that competitive equilibria with asymmetric information are always (or generically) inefficient unless agents' consumption can be fully monitored by the principal (and specified in contracts). We critically evaluate these claims in the context of a general equilibrium economy with moral hazard. We allow agents' consumption to be partially monitored (e.g., employment contracts can specify how long a vacation agent takes, but not where she spends her vacation). We identify weak separability of agents' preferences between non-monitored consumption and effort as the necessary and sufficient condition for efficiency (e.g., weak separability implies how much the agent likes Bahamas vs. Hawaii is independent of her effort level). We also establish ε-efficiency when there are only small deviations from weak separability. These results delineate a range of benchmark environments under which general equilibrium has strong efficiency properties even though agents' consumption is not fully monitored.