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FINIMPMACRO Report Summary

Project ID: 283483
Funded under: FP7-IDEAS-ERC
Country: Italy

Final Report Summary - FINIMPMACRO (Financial Imperfections and Macroeconomic Implications)

This research project has investigated four main general topics:
a. The link between financial fragility, uncertainty and macroeconomic fluctuations.
b. The desirability of fiscal policy during liquidity traps.
c. Openness, exchange rate regimes, and credibility of monetary policy.
d. Labor markets, financial stress, and the role of hiring credits.
If an economy plunges into a recession, its financial system comes under stress. At the same time, however, shocks originating from the financial system, e.g., banking crises, widely affect the economy: recessions following financial crisis are typically larger and more persistent. This mutual interaction can lead to a vicious circle (a process of so-called “financial acceleration”) which can exert a large impact on economic activity.
Against this backdrop, this research project has studied the following key question: how can an economy move abruptly from normal periods of moderate business cycles to periods of large and prolonged slumps? The answer, according to our perspective, is: because of financial fragility. Financial fragility arises in an economy where many agents reach a condition of excess accumulation of private debt, and are close to their borrowing constraint. In such a context, the economy is easily prone to phenomena of debt deleverage. Meaning, a shock of typical size (e.g., a normal slowdown in the housing market), can make that constraint suddenly binding, and force the agents to reduce their debt. This can be achieved by a sudden contraction in their consumption and investment spending, which can precipitate the economy into a recession. An interesting aspect of this dynamic is that shocks of typical size can trigger radically different effects on economic activity depending on the current level of indebtedness. In other words, in a state of financial fragility (i.e., high accumulated leverage), it is not necessary to assume "large shocks" to engineer large recessions. This is a new perspective on a key question in macroeconomics: is it realistic that great recessions are simply caused by large exogenous shocks, as if they were simply the result of “bad luck”? Why does financial fragility tend to accumulate during periods of low macroeconomic uncertainty (i.e., during 1999-2007 in most industrialized countries)?
A second key question studied by the project is the role played by fiscal policy during liquidity traps, i.e., periods in which monetary policy is constrained by the zero lower bound. In this particular state of the economy it is usually assumed that the output multiplier of government spending (i.e., how much GDP increases if an additional dollar/euro is spent by the government) is particularly large (far exceeding one). Conventional wisdom typically assumes that if the output multiplier is large, also the effect on welfare of higher government spending must be particularly large. This question has been often overlooked in the debate on the role of fiscal policy during particularly severe downturns. Our project has studied the conditions under which a large output multiplier of government spending translate also into a large welfare effect, and highlighted the fragility of this link.
A third line of research of the project has studied which exchange rate regimes are desirable in the presence (or lack thereof) of financial market imperfections. In particular, we have devoted our attention to the desirability of currency unions. The typical view is that flexible exchange rates are more desirable than currency unions (or fixed exchange rates) because of their property of shock absorbers. Our line of research has tried to challenge this conventional wisdom, showing that it typically holds only under the unrealistic assumption that policymakers have full credibility, and can directly affect the expectations of the private sector. In a more realistic world, where the monetary authority lacks its ability to commit, a monetary union can be more desirable than flexible exchange rates. This result is particularly important in light of the recent heated debate on the viability of the European single currency.
The final section of the project centered on the role of labor markets, and consisted of two sub-projects. The first explored (both theoretically and empirically) the effect of distress in financial markets on the firms' ability and willingness to hire new workers. We have proposed a new conceptual framework that explains why firms, when hit by a negative shock to their balance sheet, will decide to reduce employment. The second sub-project explored the effectiveness of temporary countercyclical hiring credits. Using comprehensive administrative data, it shows that the French hiring credit, implemented during the Great Recession, had significant positive employment effects and, simultaneously, no effects on wages. Simulations of counterfactual policies show that the effectiveness of the hiring credit relies to a large extent on its temporary nature and on high binding rigid wages. We estimate that the cost per job created by permanent hiring credits in an environment with flexible wages would have been about 14 times larger. These results bear important implications for the current debate in Europe on how to jumpstart employment in those economies where economic activity has stagnated after 2008.

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