Sowing the Seeds of Financial Crises: Endogenous Asset Creation and Adverse Selection (Job Market Paper)
Abstract: What sows the seeds of financial crises and what policies can help avoid them? To address these questions, I model the interaction between the ex-ante production of assets and ex-post adverse selection in financial markets. My results indicate that taking into account the endogenous asset supply is crucial. Positive shocks that increase market liquidity and prices exacerbate the production of low-quality assets. Indeed, I show that this can increase the likelihood of a financial market collapse. Government policies also have subtle effects. I show that an increase in government bonds increases total liquidity and reduces the incentives to produce bad assets, but can exacerbate adverse selection in private asset markets. Optimal policy balances these two effects, requiring more issuances when the liquidity premium is high. I also study transaction taxes and asset purchases, showing that policy should lean against the wind of market liquidity.
Durable Crises (joint with David Colino and Pascual Restrepo)
Abstract: Durable goods consumption is highly cyclical: it falls substantially during reces- sions and rises sharply during booms. Using U.S. County Business Patterns data between 1988 and 2014, this paper studies how durable manufacturing industries amplify business cycle fluctuations. We show that employment in durable manufacturing industries is more cyclical than in other industries, and the cyclicality is amplified in general equilibrium at the commuting zone level. We provide evidence of three mechanisms that generate amplification. First, employment changes propagate through input-output linkages, which amplify effects on local aggregate employment because industries co-locate. Second, the reduction of employment in durables negatively affects employment in non-tradable sectors, consistent with the existence of demand externalities. Third, we find that workers do not completely reallocate to other less cyclical tradable industries. Our estimates suggest that consumer durables amplify the impact of aggregate shocks on employment volatility by up to 40%.
Research in Progress
Fiscal Fragility (joint with Dejanir Silva)
Abstract: We study how the level, maturity structure and asset composition of government debt affects the severity of crises and the effectiveness of stabilization policies. We consider a small modification of the basic New Keynesian model: we assume the government has access to distortionary taxation, but not to lump- sum taxes. In contrast to the pervasiveness of multiple equilibria in the New Keynesian literature, equilibrium is now unique. Second, both fiscal and monetary policies become less powerful in high debt economies, meaning both the fiscal multiplier and the response to changes in the monetary policy are attenuated. The level of debt also has implications for how the economy responds to shocks. In response to a preference shock that pushes the economy into a liquidity trap, high debt economies experience larger and more prolonged recessions. Moreover, the maturity structure and asset composition matters. Economies with the same level of debt, but a higher fraction of long-term debt will face a smaller recession in the liquidity trap experiment. An economy with a higher fraction of long-term indexed debt will have more effective stabilization policies and it will be less affected by the preference shock. Therefore, more indebted economies and economies that rely less on long- term or indexed debt are, in this sense, more fragile.
Risk Sharing Under Limited Commitment and Private Information
Abstract: What are the limits that private information and limited commitment impose on risk sharing? Previous literature considered both problems separately, or modeled the lack of commitment only as participation constraints. However, with private information, lack of commitment does not collapse to participation constraints and requires an extended notion. I argue that this narrow understanding of limited commitment is responsible for the difficulties to find a decentralization for the constrained efficient allocation, which rely on commitment of some parties or unreasonable off-the equilibrium beliefs. I propose a notion of limited commitment involving renegotiation-proofness of the contracts, which provides a more general notion of the lack of commitment in the presence of private information. I show that there can be risk sharing with ex-post efficient contracts, and I decentralize the constrained efficient allocation a la Alvarez & Jermann (2000). Finally, I discuss the role of monitoring and retrading in sustaining the equilibrium. I argue that when information is costly, default could be a "cheap" signal to sustain some risk sharing.
Financial Frictions and Trade (joint with Rodrigo Adao and Andres Sarto)