Skip to main content

The Macroeconomics of Collateral

Periodic Report Summary 2 - MACROCOLL (The Macroeconomics of Collateral)

Financial markets constitute the backbone of modern economies, intermediating resources from those who have them (i.e. lenders) to those who can put them to productive use (i.e. borrowers). But what determines the amount and type of promises that an economy can sustain? And why, as we saw in the recent financial crisis, can this set of promises change abruptly?

This project starts from a simple premise: a defining feature of financial markets is that they entail the exchange of goods today for a borrower’s promise to deliver goods in the future. These promises are in turn sustained by guarantees, which are akin to the amount of future income that borrowers can credibly pledge to lenders. We can think of this pledgeable income as an economy’s stock of collateral. Thus, to understand the amount and type of promises that can be traded in an economy, we need to understand how the economy produces collateral.

The first part of the project deals with bubbly collateral, i.e. the possibility that current promises are backed only by the income that the sale of new promises is expected to bring in the future. In such a situation, promises are backed not by output but rather by expectations about the future. This seems like an appealing way to think about economic fluctuations in the last few decades, during which we have witnessed large swings in asset prices that seem hard to attribute to economic fundamentals.

In order to study the conditions that lead to the creation of bubbly collateral, as well as its macroeconomic effects, the PI and co-authors have first developed a workhorse macroeconomic model of bubbles. This model shows how, in a world of scarce collateral, bubbles can lead to an expansion in credit, investment, and economic growth. But bubbles are driven by expectations, and their collapse leads to a contraction in credit and a fall in investment and output. In subsequent papers, the project has built on this framework to study the interaction between financial globalization, capital flows, and bubbles, and to characterize the stabilizing role of fiscal and monetary policy in the face of bubble fluctuations.

The second part of the project deals with public collateral, i.e. promises that are issued by the government and are therefore backed by its perceived willingness to repay. On this front, the project has two empirical contributions. First of all, it has used a large-scale, bank-level dataset covering many countries and default episodes to show that sovereign defaults are associated with a decline in bank credit. These findings are consistent with the view that sovereign defaults hurt the banking system – and thus economic performance – through their holdings of sovereign bonds. Second, the project has also studied how the effects of fiscal expansions depend on one key feature: whether the public debt that they generate is purchased by domestic or by foreign residents. To this end, the PI and co-authors have constructed a novel database that tracks the evolution of domestic and foreign holdings of public debt for the United States and 16 other advanced economies over the last decades. Although this work is still ongoing, preliminary results indicate that fiscal multipliers are significantly larger in those countries and years in which a large share of the public debt is in the hands of foreigners.

The project has made other contributions, but we refer here only to one additional undertaking. In it, the PI and co-authors are trying to understand the role of the financial system in spreading collateral booms throughout the economy. To this end, they first construct a multi-sector model of an open economy with a financial system. This model shows that an expansion of collateral in one sector initially reduces the availability of credit for other sectors. If this expansion prolongs itself in time, however, it eventually raises the net worth of the banking system thereby enabling it to increase the supply of credit to all sectors in the economy. The PI and co-authors are currently gathering data from the recent credit boom in Spain to test this theoretical prediction.