Friday, December 31, 2010

Interesting Modern Macroeconomics

Everyone has opinions about macroeconomics but does anybody know what macro is these days? Knowing that I don't know, I went to Tom Sargent's webpage to find out some answers.  I read this paper that quickly brought me up to speed on the fundamental tension inherent in judging "Bank Bailout" policy.  The anticipation that banks will be bailed out preempts bank runs (Diamond and Dybvig) and this is "good" but the anticipation that banks will be bailed out creates moral hazard and excess risk taking as banks become options (throw for the endzone and if you are intercepted --- the government will pay, if you score, you win! (see Kareken and Wallace).

Sargent's paper cites Todd Keister's work.   Here is the abstract from Todd's recent paper;


Abstract

How does the belief that policymakers will bail out investors in the event of a crisis affect
the allocation of resources and the stability of the financial system? I study this question
in a model of financial intermediation with limited commitment. When a crisis occurs, the
efficient policy response is to use public resources to augment the private consumption
of those investors facing losses. The anticipation of such a “bailout” distorts ex ante
incentives, leading intermediaries to choose arrangements with excessive illiquidity
and thereby increasing financial fragility. Prohibiting bailouts is not necessarily desirable,
however: it induces intermediaries to become too liquid from a social point of view and
may, in addition, leave the economy more susceptible to a crisis. A policy of taxing
short-term liabilities, in contrast, can correct the incentive problem while improving
financial stability.

Key words: bank runs, financial regulation

This last sentence about "taxing short term liabilities" is interesting but what does it mean?  A "bank" that chooses to hold a lot of short term liabilities is at risk from a bank run.  If I collect deposits from each of my UCLA colleagues and promise them they can have the $ back at any time, I am at risk of default if there is a panic and they want their $ back on the spot.  Todd explains that with a tax on short term deposits that his model shows that "we can have the best of both worlds" of offering banks insurance without introducing moral hazard.

As  a retired macroeconomist, I think that both the Sargent paper (which represents a History of intellectual thought) and this paper by Keister highlight the relevance of macro. Perhaps, I should return to Chicago for a refresher course?

UPDATE:   Here is another interesting NYU Macro paper.  Similar to my thinking about climate change adaptation, note that the authors model the agent as "knowing that he does not know" the stochastic process of underlying shocks in the economy and having a desire to minimize risk exposure if the true state of the world turns ugly.  This is "robustness" at work.

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