Liquidity Crises, Currency Crises, and Currency “Wars”

1. Liquidity Crises, Currency Crises, and Currency “Wars” Assaf Razin 2018

2. Road Map Scope • Banking Crises Currency and Twin Crises • Currency “Wars” • The Euro Crisis • Conclusion

3. The 2008 turmoil • World financial markets exhibit ingredients from all types of financial crises in history: • Banking crises • Currency crises • Credit frictions • Market freezes • Asset bubbles booming and Busting • Sovereign Debt Fragility, especially within Single Currency Areas

4. Types of Fragility • Coordination failure Banks rely on the fact that only forecastable fraction of depositors will have short term liquidity needs. But there is self fulfilling equilibrium where all depositors demand early withdrawal (Diamond and Dybvig). • Strategic Complementarity More depositors withdraw their money the bank is more likely to fail and so other depositors have a stronger incentive to withdraw.

5. Moral hazard in Credit Markets The borrower has the ability to divert resources to himself at the expense of the creditor. This creates a limit on credit. The limit can get tightens when economic conditions worsen (Holmstrom and TirolePrincipal-Agent framework). • Risk Shifting An investor who borrow to buy assets benefits from the upside while having limited exposure to the downside risk (Risk shifting Allen and Gale model). • Leverage Cycles The optimists-pessimists composition in the investor population shifts endogenously as a cause for the birth and death of leverage bubbles (Geanakoplos). • Fragilities of Monetary and exchange rate arrangements • European Monetary System and lender of last resort (a EMU member central bank cannot print money—Paul De Grauwe).

6. Panic-Based Banking Crises

7. Banking Crises • Depository institutions are inherently unstable, because they finance long-term investments with short-term deposits • The maturity mismatch exposes banks to the risk of bank runs: when many depositors demand their money in the short term, banks will have to liquidate long-term investments at a loss

8. Diamond-Dybvig Economy • three periods (0,1,2), one good, and a continuum [0,1] of agents • Each agent is born in period 0 with an endowment of one unit • Consumption occurs in period 1 (c1) or 2 (c2) • Each agent can be of two types: With probability  the agent is impatient and with probability 1- she is patient

9. Diamond-Dybvig economy • Agents’ types are i.i.d.; we assume no aggregate uncertainty • Agents learn their types (which are their private information) at the beginning of period 1 • Impatient agents can consume only in period 1. They obtain utility of • Patient agents can consume at either period; their utility is

10. Diamond-Dybvig economy • Agents have access to a productive technology that yields a higher expected return in the long run. • Utility function u is increasing, and for any c>1 has a relative risk-aversion coefficient >1; u(0)=0

11. Banking CrisesDiamond-Dybvig economy • Formulation Based on Goldstein and Pauzner (2005). • For each unit of input in period 0, the technology generates one unit of output if liquidated in period 1 • If liquidated in period 2, the technology yields R units of output with probability p(), or 0 units with probability 1-p() •  is the state of the economy, drawn from a uniform distribution on [0,1], unknown to agents before period 2 • p() is strictly increasing in , To create incentive for patient depositors to delay withdrawals to period 2:

12. Autarky • In autarky, impatient agents consume one unit in period 1, whereas patient agents consume R units in period 2 with probability p() • Because of the high coefficient of risk aversion, a transfer of consumption from patient agents to impatient ones could be beneficial, ex ante, to all agents, although it would necessitate the early liquidation of long-term investments

13. All-Knowing Social Planner • A social planner who can verify agents’ types, once realized, would set the period-1 consumption level c1 of the impatient agents so as to maximize an agent’s ex-ante expected welfare: The first-best period-1 consumption is set to maximize this ex-ante expected welfare

14. Banking CrisesRisk Sharing via Maturity Transformation • units of investment are liquidated in period 1 to satisfy the consumption needs of impatient agents • As a result, in period 2, each of the patient agents consumes with probability • The first-best period-1 consumption is set to maximize this ex-ante expected welfare

15. Banking CrisesRisk Sharing via Maturity Transformation • The condition equates the benefit and cost from the early liquidation of the marginal unit of investment • , • period 1 consumption of impatient consumers exceeds the endowment available in period 1: • There is risk sharing, which is achieved via maturity transformation: the transfer of wealth from patient agents to impatient ones so as to provide insurance in period 0.

16. Banks • Assume that the economy has a banking sector with free entry, and that all banks have access to the same investment technology. • Since banks make no profits due to perfect competition, they offer the same contract as the one that would be offered by a single bank that maximizes the welfare of agents

17. Banks and Multiple Equilibria • Suppose the bank sets the payoff to early withdrawal r1 at the first-best level of consumption • If only impatient agents demand early withdrawal, the expected utility of patient agents is

18. Banking Crises Banks and Multiple Equilibria • As long as this is more than the utility from withdrawing early , there is an equilibrium in which, indeed, only impatient agents demand early withdrawal. • In this equilibrium, the first-best allocation is sustained. • However, as Diamond and Dybvig point out, the demand-deposit contract makes the bank vulnerable to runs.

19. Banking Crises Banks and Multiple Equilibria • The second equilibrium: all agents demand early withdrawal. • When they do so, period-1 payment is r1 with probability 1/r1 and period-2 depositor payoff is 0, so that it is indeed optimal for agents to demand early withdrawal. • This coordination-failure equilibrium is welfare inferior to the autarkic regime.

20. Banking Crises withdrawal timing and depositor payoffs Ex Post Payments to Agents

21. Multiple Equilibrium and Welfare Ranking

22. Common Knowledge vs. Private Knowledge • Begin with common knowledge about the fundamental stochastic θ • The possible equilibrium outcomes depend on which one of three regions the fundamental θ:

23. Common Knowledge • Below a threshold, there is a unique equilibrium where all depositors – patient and impatient – run on the bank and demand early withdrawal. • Above a threshold, there is a unique equilibrium where patient depositors do not withdraw. • Between the two thresholds, there are multiple equilibria.

24. Uncommon Knowledge: Unique Equilibrium • Introducing noise in speculators’ information about θ dramatically changes the predictions of the model, even if the noise is very small • The intermediate region between θ and θ is split into two sub-regions: below θ*, a run occurs bank fails, while above it, there is no run and

25. Heterogeneous Signals and Unique Equilibrium • Due to the noise in patient depositors’ information about , their decisions about whether to withdraw no longer depend only on the information conveyed by the signal about the fundamental, but also depend on what the signal conveys about other depositors’ signals • Hence, between θ and θ, depositors can no longer perfectly coordinate on any of the outcomes, as their actions now depend on what they think other depositors will do at other signals

26. Banking Crises Heterogeneous Signals and Unique Equilibrium • A depositor observing a signal slightly below knows that many other depositors may have observed signals above and chose not to run. • Taking this into account, she chooses not to run. • Then, knowing that depositors with signals just below are not running on the bank, and applying the same logic, depositors with even lower signals will also choose not to run. • This logic can be repeated again and again, establishing a boundary well below , above which depositors do not run on the bank.

27. Banking Crises Heterogeneous Signals and Unique Equilibrium • The same logic can then be repeated from the other direction, establishing a boundary well above θ, below which depositors do run on the bank • The mathematical proof shows that the two boundaries coincide at a unique θ*, such that all depositors run below θ* and do not run above θ*

28. Banking Crises Heterogeneous Signals and Unique Equilibrium • In the range between θ and , the level of the fundamental now perfectly predicts whether or not a crisis occurs. In particular, a crisis surely occurs below . • We refer to crises in this range as “panic-based” because a crisis in this range is not necessitated by the fundamentals; it occurs because agents think it will occur, and in that sense it is self-fulfilling. • However, the occurrence of a self-fulfilling crisis here is uniquely pinned down by the fundamentals.

29. Probability of Runs • Knowing when runs occur, one can compute their probability and relate it to the terms of the banking contract. Goldstein and Pauzner (2005) show that banks become more vulnerable to runs when they offer more risk sharing. • That is, the threshold θ* , below which a run happens, is an increasing function of the short-term payment offered to depositors r1

30. Deposit Contracts • However, even when this destabilizing effect is taken into account, banks still increase welfare by offering demand deposit contracts • Characterizing the short-term payment in the banking contract chosen by banks taking into account the probability of a run, they show that this payment does not exploit all possible gains from risk sharing, since doing so would result in too many bank runs. • Still, in equilibrium, panic-based runs occur, resulting from coordination failures among bank depositors. This leaves room for government policy to improve overall welfare.

31. Deposit Insurance • One of the basic policy remedies to reduce the loss from panic-based runs is introduction of deposit insurance by the government. • This idea goes back to Diamond and Dybvig (1983), where the government promises to collect taxes and provide liquidity (bailout) to the bank in case the bank faces financial distress • In the context of the model described above, with deposit insurance, patient agents know that if they wait they will receive the promised return independently of the number of agents who run • Hence, panic based runs are prevented: patient agents withdraw their deposits only when this is their dominant action

32. Deposit Insurance • Extending the context of the above model, Keister (2011) has highlighted another benefit of deposit insurance: it helps providing a better allocation of resources by equating the marginal utility that agents derive from private consumption and public-good consumption. • That is, when bank runs occur, private consumption decreases, generating a gap between the marginal utility of private consumption and that of public-good consumption, so with bailouts, the government can reduce the public good and increase private consumption to correct the distortion.

33. Moral Hazard • However, deposit insurance also has a drawback, as it creates moral hazard: when the bank designs the optimal contract, it does not internalize the cost of the taxes that might be required to pay the insurance. • Thus, the bank has an incentive to over-exploit the deposit insurance by setting r1 higher than the socially optimal level.

34. Bank finance and Modigliani-Miller paradigm • Modigliani and Miller tell us that profitable new investment could be financed by selling new shares of stock in the bank as well as borrowing more money from depositors. But the primary reason that the cost of financing investment depend on the mix of debt and equity is that another party bears the difference in costs. In particular, when the government insures a bank’s creditors then increasing the fraction of debt financing can increase the value of this • insurance from the government.

35. Bank owners prefer debt finance over equity finance Under Bailout Policies • Increasing the bank’s debt may make the bank’s owners better off at no cost to the creditors. But the bank’s gains would be at the expense of the tax-paying public, which is bearing risks that private investors would not accept without being paid a greater interest premium. Public insurance enables banks to borrow at low rates that do not properly respond to greater risks that their creditors must bear when the bank has less equity.

36. FX Market Intervention by the Central Bank: Basics

37. Sterilized purchase of foreign assets Figure 5B: Sterilized Foreign Exchange Market Intervention

38. Currency and Twin Crises

39. Currency Crises • Governments/central banks try to maintain certain financial and monetary arrangements, most notably a fixed-exchange rate regime, or more recently, a regional monetary union. Their goal is to stabilize the economy or the region. • At times, these arrangements become unstable and collapse leading to debt and banking crises (surveyed in the previous sections). • This strand of the literature analyzes currency crises characterized by a speculative attack on a fixed exchange rate regime.

40. Currency Crises • The best way to understand the origins of currency crises is to think about the basic tri-lemma in international finance. • A tri-lemma is a situation in which someone faces a choice among three options, each of which comes with some inevitable problems, so that not all the three underlying policy objectives can be simultaneously accomplished.

41. Currency Crises In international finance, the tri-lemma stems from the fact that, in most nations, economic policy makers would like to achieve the following goals. First, make the country’s economy open to international capital flows, because by doing so they let investors diversify their portfolios overseas and achieve risk sharing. They also benefit from the expertise brought to the country by foreign investors. • Second, use monetary policy as a tool to help stabilize inflation, output, and the financial sector in the economy. This is achieved as the central bank can increase the money supply and reduce interest rates when the economy is depressed, and reduce money growth and raise interest rates when it is overheated. Moreover, it can serve as a lender of last resort in case of financial panic.

42. Currency Crises • Third, maintain stability in the exchange rate. This is because a volatile exchange rate, at times driven by speculation, can be a source of broader financial volatility, and makes it harder for households and businesses to trade in the world economy and for investors to plan for the future. • The problem, however, is that a country can only achieve adequately two of these three goals.

43. Currency Crises • By attempting to maintain a fixed exchange rate and capital mobility, the central bank loses its ability to control the interest rate or equivalently the monetary base – its policy instruments – as the interest rate becomes anchored to the world interest rate by the interest rate parity and the monetary base is automatically adjusted. • This is the case of individual members of the EMU. • In order to keep control over the interest rate or equivalently the money supply, the central bank has to let the exchange rate float freely, as in the case of the US.

44. Currency Crises • If the central bank wishes to maintain both exchange rate stability and control over the monetary policy, the only way to do it is by imposing domestic credit controls and international capital controls, as in the case of China. • Currency crises occur when the country is trying to maintain a fixed exchange rate regime with capital mobility, but faces conflicting policy needs, such as fiscal imbalances or fragile financial sector, that need to be resolved by independent monetary policy, and effectively shift the regime from the first solution of the trilemma described above to the second one.

45. Two Open Economy Trilemmas • The Macroeconomic classic—fixed exchange rate, capital flows, independent monetary policy; • The Financial Sector– fixed exchange rate, capital flows, financial stability; (e.g., Cyprus, Greece—members of Euro)

46. The EMS 1979–1998 • Because of differences in monetary and fiscal policies across the EMS, market participants began buying German assets (because of high German interest rates) and selling other EMS assets. • As a result, Britain left the EMS in 1992 and allowed the pound to float against other European currencies. • As a result, the exchange rate mechanism was redefined in 1993 to allow for bands of +/–15% of the target value in order devalue many currencies relative to the deutschemark.

47. Currency CrisesFirst-Generation Model of Currency Crises • This branch of models, the so-called ‘first generation models of currency attacks’ was motivated by a series of events where fixed exchange rate regimes collapsed following speculative attacks, for example, the early 1970s breakdown of the Bretton Wood global system. • The first paper here is the one by Krugman (1979). • He describes a government that tries to maintain a fixed exchange rate regime, but is subject to a constant loss of reserves, due to the need to monetize government budget deficits.

48. U.S. External Balance Problems Under Bretton Woods The collapse of the Bretton Woods system was caused primarily by imbalances of the U.S. during the 1960s and 1970s. The U.S. current account surplus became a deficit in 1971. Rapidly increasing government purchases increased aggregate demand and output, as well as prices. Rising prices and a growing money supply caused the U.S. dollar to become overvalued in terms of gold and in terms of foreign currencies.

49. Currency CrisesFirst-Generation Model of Currency Crises • These two features of the policy are inconsistent with each other, and lead to an eventual attack on the reserves of the central bank, that culminate in a collapse of the fixed exchange rate regime. • Flood and Garber (1984) extended and clarified the basic mechanism, suggested by Krugman (1979), generating the formulation that was widely used since then.

50. Currency CrisesFirst-Generation Model of Currency Crises • The problem is that this process cannot continue forever, since the reserves of foreign currency have a lower bound. • Eventually, the central bank will have to abandon the solution of the trilemma through a fixed exchange rate regime and perfect capital mobility to a solution through flexible exchange rate with flexible monetary policy (i.e., flexible monetary base or equivalently domestic interest rate) and perfect capital mobility.