Assets

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Interview-Markus-Brunnermeier

16


y Wenqian Huang

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Creating

Safe

Assets

Interview with Markus K. Brunnermeier*

*

Edwards S. Sanford Professor

of Economics and Director of

the Bendheim Center for Finance,

Princeton University

TI: To start the interview, I’d first like to

ask what you think is the root cause of

the Euro zone crisis? Is it a sovereign debt

crisis or a sudden-stop crisis?

MB: I think it is arguably more of a

sudden-stop crisis, but sovereign debt

problems also played a role. A significant

amount of the cross-border credit flows

were financed short-term on the interbank

market. The classic example is that

peripheral banks granted local long-term

mortgage loans, which they refinanced

short-term on the interbank market.

A large fraction of banks’ funding was

so-called wholesale funding, as opposed

to domestic deposit funding. When the

interbank market froze— the sudden

stop— the ECB stepped in as intermediary

and TARGET2 balances skyrocketed. In

addition, in some countries, governments

borrowed excessively— mostly from

abroad. Hence, sovereign debt also played

a role. When private investors refused to

roll over the funding, the official sector

stepped in, and a lot of the private debt

became sovereign debt.

TI: Was it then a classic liquidity problem?

MB: Not quite. Prior to the crisis we

observed large capital flows in the

peripheral countries. One view was that

these countries borrowed in order simply

to catch up with the core countries.

According to this “convergence view”,

a temporary disruption is an inefficient

run and should be counteracted aggressively.

In contrast, the “imbalance view”

argues that imbalances and bubbles were

building up which were not sustainable in

the long run. Instead of investing wisely,

which would have led to increases in (total

factor) productivity, GDP was artificially

pumped up without an increase in

productivity measures. The sudden stop,

hence, was not only a liquidity run; it also

had an element of correction. Part of the

problem was a solvency problem. Of

course, when a correction occurs, markets

tinbergen magazine spring 2016 17

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tend to overreact— and this calls for

a well-tuned intervention.

TI: For the Euro zone as a currency union,

what do you think about the European

quantitative easing (QE) policy? Does the

current monetary policy increase inflation

risk and create bubbles for the next crisis?

MB: It depends on what kind of underlying

problem one tries to solve and what the

alternatives are. If the underlying problem

is that real wages are too high in the

peripheral countries (and hence they are

not competitive), then the solution for

this problem is to meet the inflation

target at least in core countries such as

Germany. So any central bank intervention

should primarily be targeted at the core

countries.

If the underlying problem is peripheral

countries suffering from balance sheet

impairment, then QE can subsidize the

peripheral countries. It can help the

balance sheets of peripheral countries by

pushing down the interest rates. In this

sense, QE is redistributive— but might

ultimately help the whole euro area.

After one has identified the underlying

problem, it is not obvious that QE is the

best instrument to tackle the problem.

For example, if the underlying problem is

the difference in competitiveness, then

an alternative policy comes to mind: for

example, an active communication policy

by the central bank that tries to impact

the wage bargaining, say, in Germany.

Central banks should “talk up wages” in

core countries. This would help close the

real wage gap between the peripheral

countries and the core countries. This is

essentially the opposite of what central

banks did in the 1970s when they tried

to “talk down” inflation during a high

inflation period.

TI: Do you think the peripheral countries

have incentives to be over-indebted?

How should the currently high public

debt ratio in these countries be reduced?

Will austerity measures alleviate or

worsen the current situation?

MB: Over the next decades the debt

ratio can come down. If you look at the

debt-to-GDP ratio, you can reduce this

ratio by either increasing GDP or decreasing

debt. It is important that government debt. They are safe in nominal terms

debt will increase by less than GDP.

because the central banks can always

print money to pay off the debts. Within

Austerity is usually associated with two a currency union, however, one cannot

things: a reduction in expenditures and do this anymore. Individual sovereigns

implementation of structural reforms. cannot print Euros. The sovereign debts

However, both measures are independent are as if foreign-denominated sovereign

of each other. A smart approach would debts. Thus, sovereign debt in the EU has

provide some reward for growth-enhancing

structural reform. Knowing that

default risk and liquidity risk.

structural reform measures are contractionary

in the short-run and only yield a asset for Europe, which can be treated as

The idea of ESBies is to create a really safe

higher GDP growth rate in the intermediate

and long run, politicians are reluctant the risky sovereign debts, banks can hold

safe assets for banks. Instead of holding

to undertake them. To encourage

ESBies, which are not risky at all. The way

structural reform for the long-term

that ESBies work is to pool (up to a limit)

growth, our fiscal rules should be such the sovereign debts in Europe, and to issue

that they provide compensation for senior and junior bonds such that the

short-term growth costs in the form junior bonds protect the senior bonds.

of a small stimulus program.

So the senior bonds are very safe and the

risk is all concentrated in the junior bonds.

TI: You proposed, together with the The senior bonds are held by banks and

Euro-nomics group 1 , European Safe Bonds the junior bonds are held outside of the

(ESBies) as a way out of the Euro zone banking sector. Whenever there is a

crisis. What are the advantages of ESBies? negative shock, the senior bonds are

always safe and the banks do not suffer

MB: ESBies are not a panacea, but they from the double diabolic loop. That is the

solve two specific problems. The double first advantage of ESBies: to switch off the

diabolic loop between the financial sector diabolic loop, which reduces overall risk

and the sovereign risk is at the center and makes the junior bond also less risky.

of the Euro Crisis. When sovereign debts

lose in value, banks that hold a significant The second advantage of ESBies is to

amount of sovereign debt on their balance redirect the cross-country capital flow.

sheet suffer capital losses. This lowers Right now, as the crisis intensifies, capital

their equity, leading them to scale back flies across borders to the core countries

their activities and grant fewer loans to since the safe asset is asymmetrically

the rest of the economy. As a consequence,

the real economy is slowing down junior bonds to senior bonds. Both bonds

supplied. With ESBies, capital flows from

and tax revenue declines. As tax revenues are European bonds; and the safe asset is

decline, sovereign debt becomes less a European asset but not a German asset.

sustainable and, in turn, riskier. That is the So there is no cross-border capital flow,

first diabolic loop. At the same time, there which stabilizes the whole system.

is a second diabolic loop at work. When

banks lose value, the bailout probability TI: Does your new book with Harold James

also goes up. This, in turn, makes the

and Jean-Pierre Landau, entitled “The Euro

sovereign debts riskier and lowers their and the Battle of Ideas”, describe the

prices— which in turn hits banks and ESBies?

increases the probability of a costly

bailout. Both of these amplification

MB: Yes, indeed. Readers interested in

mechanisms enable a small negative learning more about this subject should

shock to have large implications.

read our forthcoming book. It will be

available from the end of August onwards.

To solve this double diabolic loop, one However, the book is much broader in

needs safe assets that are truly safe. scope than ESBies. It explains how

Typically, the safe assets are government different economic philosophies, primarily

1 Euro-nomics is by a group of nine European academic economists, whose objective is to provide concrete,

carefully considered, and politically feasible ideas to address the euro area's current problems.

18


etween Germany and France, complicated

the crisis management. It explains

how— starting with fiscal problems in one

of Europe’s smallest economies, Greece, in

late 2009— a long-simmering battle over

the appropriate economic philosophy and

future design of the European Union broke

into the open. It is a struggle between

northern (above all, German) and what are

sometimes called southern (but above all,

French) theories. The former emphasize

rules, rigor and consistency, while the

latter focus on the need for flexibility,

adaptability and innovation.

“The idea of ESBies is to

create a really safe asset

for Europe, which can be

treated as safe assets for

banks.”

TI: How do you view the future of Euro?

Do you think Euro will disappear in future?

MB: I am confident that the Euro will

survive. We experience challenging times,

but the US Dollar also had to face its

challenges in its early phase. The Euro

framework will be adjusted and modified

as we move along. But the question is

what could be the alternative. Let’s say…

if we were to have totally floating

exchange rates. That would be a big

problem within Europe as well. People

always have the impression that there are

some problems in the current framework,

and if we think about the alternative

everything would be hunky dory. But it

won’t be. Because even before we had the

Euro, we had a currency crisis and we had

many problems as well. The problems will

reappear, but people just don’t think about

these problems. So the alternative is not

all that glossy either. It is not a perfect

world.

TI: Before the global financial crisis,

central bankers knew a lot about labor

markets, product markets, inflation,

output and its relation to fiscal and

monetary policy. But the whole 'liquidity'

and financial intermediation sector was

missed. Do you think we are going to the

other extreme: that in the post-crisis era

we are now missing the 'real' side of the

economy?

MB: I don’t think so. I think there was too

little emphasis on the financial side before

the crisis. Now the profession is picking

up. There is still a lot of catching-up to do,

and many young economists focus on the

interaction between the macro economy

and the financial side. But there are also

many economists working on the real side.

Many economists have built up their

human capital on labor market issues

and other real side aspects. Overall,

I don’t think that the financial research

is overshadowing the real side at all.

I think we have a more healthy balance

now.

TI: Where do you believe that macro and

finance are heading? For our MPhil

students, what will be the “hot topics”

for the next few years?

MB: How to better understand risks and

how to prevent and get out of a crisis

are some hot topics. Risk comes in many

facets: fundamental risk is different from

endogenous and systemic risk. The latter

is time-varying and depends on balance

sheet constraints. In addition, the risk

premium investors require is also timevarying

and hence contributes to the

endogenous time-varying risk. Currently,

monetary economics (and its interaction

with finance) is being reinvented. There

will be a modern revival of the field

“money and banking” within macro

models. Another interesting research

agenda has to do with safe assets and

their roles in the global financial system.

How should one set up a stable global

financial system?

I think these are just a few hot topics.

New techniques, including continuous

time technique, will allow us to dive more

deeply into these topics than ever before.

I expect a lot of new insights and a better

understanding of the interaction between

monetary and financial stability as well as

fiscal debt sustainability.

TI: Speaking of the new techniques, what

are the techniques that every macro and

finance researcher should have (but

typically doesn’t)?

MB: I think macro and finance can learn

from each other. The historical grand

masters of economics wrote a lot about

the interaction between macro and

finance. Keynes wrote about it; Irving

Fisher wrote about it. After the Second

World War, finance focused more on

the static stochastic models in order to

capture the risk components, while macro

focused more on the dynamic deterministic

models. In the 1970s, macro started to

formally incorporate the risk aspect as

well, and finance got into the dynamic

aspect. But they did it in different ways.

Macro did it in discrete time because of

the quarterly data; finance did it in

continuous time because finance has

much more frequent data.

Both branches of economics developed

useful tools. For example, continuous

time tools, like stochastic calculus from

finance, allow much deeper analysis on

the time-varying risk premium and the

endogenous time-varying risk itself.

On the empirical side, tons of new data

are now available. These will lead to a lot

of interesting empirical analyses— and

will improve our understanding of what is

going on and which theoretical channels

are quantitatively more important.

tinbergen magazine spring 2016 19

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