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Monetary policy and corporate default discussion
Journal of Monetary Economics 58 (2011) 495–497
Contents lists available at ScienceDirect
Journal of Monetary Economics journal homepage: www.elsevier.com/locate/jme
Discussion
Monetary policy and corporate default discussion ~ F. Gomes Joao London Business School and The Wharton School, University of Pennsylvania, United Kingdom
1. Introduction It is a considerable understatement to suggest that the optimal response of monetary and fiscal policy to the large movements in financial markets is not well understood. That this is so can be gathered by the sheer volume of space devoted over the last few years to academic contributions, policy papers and popular commentary in general. Unfocused academic research must shoulder some of the blame for this state of affairs and sadly there is still a remarkable lack of solid workhorse quantitative models than can be used for macroeconomic analysis in the presence of financial market frictions. Several of the theoretical underpinnings of financial crises have been fairly well understood for generations, and much world class theory has been done in the last 20 years. Unfortunately, much of it remains at a level of abstraction that reduces its usefulness for applied macroeconomics analysis which places a very high premium on specific quantitative implications. Thus, with the possible exception of Bernanke et al. (1999) and perhaps also Kiyotaki and Moore (1997) and Carlstrom and Fuerst (1997) it has proved difficult to capture the essential aspects of financial markets in a tractable quantifiable way. Moreover, although these models represent important early steps their limitations are also becoming rather too apparent to those wishing to use them in practical applications. Credit constraints may well be important, but it is hard to believe they can explain why leverage ratios rose so high between 2005 and 2008 or so. Aggregate data also suggests that an hypothetical aggregate firm of the type used in these models would have more than enough cash in its balance sheet not to depend very heavily on external resources if it so wished. Equally significant is the fact that recessions are often sharp and deep, particularly so in credit markets, and looking nothing like the smooth linear events produced by these simple aggregate models. Finally, and perhaps even more damaging is the fact that the entire transmission mechanism in these early models relies on grossly counterfactual patterns in asset markets, and generally ignores entirely the role to risk premia in the economy. Although not yet a fully developed alternative, this paper represents an attempt to develop a new framework that begins to address some of the shortcomings in the existing literature.1 It investigates the expected effect of monetary policy and expected inflation on corporate default and credit spreads. Although the current paper’s focus on the potential for debt deflations to exacerbate the effects of underlying real shocks is not new, the authors bring a much expanded set of tools that can be used to explicitly analyze the role of debt markets and prices on default decisions of firms and develop important policy implications. 2. Key model assumptions and discussion 2.1. Credit risk The basic setting combines elements from the new generation of credit risk models with classical staples from the monetary economics literature such as interest rate rules in a somewhat stylized equilibrium setting. General equilibrium links risk pricing to macro quantities and, in a monetary setting with nominal debt contracts, to monetary policy and interest rates. E-mail address: [email protected] Other recent papers offering new and richer insights into the role of financial markets in the macroeconomy include Brunnermeier and Sannikov (2010), Gertler and Kiyotaki (2010), Gilchrist et al. (2010), Gomes and Schmid (2010, 2011), Gourio (2010) and Jermann and Quadrini (2010). 1
0304-3932/$ - see front matter & 2011 Elsevier B.V. All rights reserved. doi:10.1016/j.jmoneco.2011.05.009
496
J.F. Gomes / Journal of Monetary Economics 58 (2011) 495–497
In its key features the equilibrium credit risk model is similar to that of Bhamra et al. (2010) and relies on the pricing of corporate credit by risk averse investors.2 The fundamental element is the assumption of endogenous default by equity holders, triggered by the excessive burden of debt relative to expected future cash flows. It is the nature of this optimal decision that will link bankruptcy losses to macroeconomic conditions in general and monetary policy in particular. Corporate credit takes the form of long-lived nominal bonds issued at the initial date of birth for the firm, and requiring regular coupon payments. Long-lived debt has various implications but it is very tractable because it removes the need to optimize periodically and makes it easier to keep tract of cross-sectional differences across firms. The long maturities add to the underlying risk of default and make it easier to generate plausible credit spreads, at least when compared with other models with one-period debt contracts. 2.2. Real business cycles and amplification mechanism The current paper does not consider corporate investment at all. Eliminating investment reduces the distance between consumption and output and greatly facilitates aggregation. This links consumption and (asset) prices more directly a result that is even more valuable here than in simpler monetary theory settings. A second very important benefit is that it again significantly reduces the complexity of the decisions facing firms in every period. Of course while this is a convenient simplification that is not without precedent in many recent monetary models it is clearly not ideal. Without firm level investment what generates cyclical fluctuations in output, besides the underlying exogenous shocks? In principle are two possibilities in these models. The first is cyclical entry and exit but the authors choose not to pursue this route too far by simply assuming that each exiting firm is simply replaced by a new entrant (or alternatively just reorganized).3 However, the current model easily generates countercyclical exit rates and a more developed framework that allows for endogenous entry would significantly enhance the ability of the credit mechanism outlined here to amplify shocks. The main mechanism employed here, however, is the fluctuation in aggregate losses due to credit defaults which are also markedly countercyclical. Although most of these investor losses are treated as pure redistribution across households a (very) small fraction are considered to be deadweight costs as a whole. The concentration of credit losses in recessions generates a potentially sharp drop in output and consumption, making these events look a lot more like the data. With endogenous investment (or firm entry) the worsening in expected credit losses would also make it more difficult to fund new projects or firms further denting short term economic growth.4 Moreover, the rise in consumption volatility leads to a potentially large (depending on preferences) increase in risk premia and significant widening in credit spreads which is also much more in line with the data. This effect is not discussed in the paper because it is probably small but its magnitude will depend on what is assumed for the value of the deadweight losses. The overall magnitude of these bankruptcy costs is a subject of considerable debate in the corporate finance literature, but the authors estimate of about 20% of asset value does not seem unreasonable. By generating large enough credit losses it allows them to obtain plausible values for credit spreads in the model, something that it is extremely hard to do in Bernanke et al. (1999). More controversial perhaps is the assumption of very low deadweight losses, although the evidence here is quite limited. The main consequence of calibrating the model to this low number is that it again severely limits the impact of any shocks on aggregate consumption and income over the cycle. In fact if these losses were entirely rebated, aggregate consumption and output would be not be endogenous at all in this model. Allowing for even a small amount of aggregate losses means that the equilibrium default rate, and thus the crosssectional heterogeneity in firms that determines it, will matter for the aggregate behavior of the economy. This is potentially a significant computational burden, and clearly something the authors try to minimize with their assumptions of ‘‘near-aggregation’’. In spite of these simplifications the nonlinearity of the optimal default decision in itself has one very important benefit: it allows the model to generate extremely asymmetric business cycles with very sharp recessions, characterized by large waves of corporate defaults. This is just one widely documented fact about credit markets that financial accelerator type models cannot address at all. 2.3. Monetary policy While the basic insights from the real fluctuations are quite similar to those in other recent papers the main novelty of the this work is its focus on monetary policy. As in new-keynesian models the link between monetary policy and real activity relies on nominal rigidities. Here, however, these rigidities take the form of long-lived corporate bonds that demand periodic nominal repayments. As discussed earlier this implies that rises in real interest rates will change the real burden of debt to firms and the incentives for corporate defaults. Because these in turn impact real output and aggregate consumption, sticky debt acts very much like sticky prices in classical monetary models. This is perhaps the core idea of the paper and one that perhaps should attract much more attention from future researchers. 2
Here, however, and presumably for tractability, these investors have standard power utility over real consumption. In practice exiting firms will on average be less productive that new entrants which draw their productivities from an unconditional distribution. However, this difference does not seem to play a major role in the findings. 4 See Gomes and Schmid (2010) for example. 3
J.F. Gomes / Journal of Monetary Economics 58 (2011) 495–497
497
To exploit these ideas the authors assume that monetary policy takes the form of a stochastic rule that links nominal interest rates to inflation, output and temporary monetary policy shocks. The important thing is that now both output and inflation will depend on aggregate default rates. This raises the issue of whether monetary policy should respond to credit market conditions and, more precisely what is the optimal monetary policy in this setting. The authors avoid a direct answer and chose instead to approach this issue with caution, by illustrating the consequences of different rules for economic performance following adverse shocks. These monetary policy exercises confirm our basic intuition that a debt deflation spiral follows when the central bank follows a passive nominal interest rate target. Again this is not really surprising, since as real interest rates are allowed to fluctuate the real burden of corporate debt moves as well and so do corporate defaults. As expected a more intelligent monetary policy that targets inflation can mitigate these effects, but the most important finding and possibly the main novelty in the paper is formalized in Proposition 1. This proposition establishes that (linear) inflation targeting also requires monetary policy to respond to credit market data. In the paper the authors focus on targeting aggregate default rates directly but it is much more likely, however, that a practical application would use a measure of credit spreads instead. Data on credit spreads is very easy to obtain and forward looking containing much information about expected future defaults probabilities and expected losses. This result is extremely important because it specifically shows the shortcomings of simple monetary policy rules that ignore financial market data. Conversely if shows how useful financial market data can be for policy makers attempting to forecast, and react to, expected economic performance. There is such a gap in this literature that it is difficult to anticipate the generality of this finding. It is obvious that the cross-sectional distribution of firms is an important state variable and that moments of that distribution, such as default rates, could be useful, to predict prices and quantities. But it is not clear at this stage what would be useful summary statistics for this and whether variables such as output and inflation would not be enough to mop up most of the relevant information. Crucial as this issue is, it must remain as an open question for future research. 3. Conclusion In a strange paradox the progressive rise of financial economics as a separate field has led to increasing neglect of finance as a subject by most macroeconomists, who prefer instead to concentrate on labor and goods market frictions alone. Surely this neglect is now at an end. The internet boom of the 1990s and now the financial crisis have made it increasingly difficult for macroeconomist to overlook the importance of financial markets to the economy as a whole. This paper is part of a renewed agenda to incorporate frontier developments in corporate finance and asset pricing into modern macroeconomic settings that are also suitable for policy analysis. It offers some important insights into what monetary policy might look like in a world with heterogeneous firms and optimal defaults. At this stage the model should be viewed as a suggestive illustration. The tension between allowing credit frictions to produce meaningful propagation mechanisms and preserving a modicum of computational tractability, undoubtedly limits its application but no more so than in so many other monetary policy models. References Bhamra, H., Kuehn, L.-A., Strebulaev, I., 2010. The aggregate dynamics of capital structure and macroeconomic risk. Review of Financial Studies 23 (12), 4187–4241. Bernanke, B., Gertler, M., Gilchrist, S., 1999. The financial accelerator in a quantitative business cycle framework. In: Woodford, M., Taylor, J. (Eds.), Handbook of Macroeconomics. North Holland. Brunnermeier, M., Sannikov, Y., 2010. A macroeconomic model with a financial sector. Working paper, Princeton University. Carlstrom, C., Fuerst, T., 1997. Agency costs, net worth, and business fluctuations: a computable general equilibrium analysis. American Economic Review 87 (5), 893–910. Gertler, M., Kiyotaki, N., 2010. Financial intermediation and credit policy in business cycle analysis. Working paper, Princeton University. Gilchrist, S., Yankov, V., Zakrajsek, E., 2010. Credit market shocks and economic fluctuations: evidence from corporate bond and stock markets. Working paper, Boston University. Gomes, J.F., Schmid, L., 2010. Equilibrium credit spreads and the macroeconomy. Working paper, Duke university. Gomes, J.F., Schmid, L., 2011. Credit sensitive monetary policy. Working paper, Duke University. Gourio, F., 2010. Credit risk and disaster risk. Working paper, Boston University. Jermann, U., Quadrini, V., 2010. Macroeconomic effects of financial shocks. Working paper, University of Pennsylvania. Kiyotaki, N., Moore, J., 1997. Credit cycles. Journal of Political Economy 105 (2), 211–248.
Contents lists available at ScienceDirect
Journal of Monetary Economics journal homepage: www.elsevier.com/locate/jme
Discussion
Monetary policy and corporate default discussion ~ F. Gomes Joao London Business School and The Wharton School, University of Pennsylvania, United Kingdom
1. Introduction It is a considerable understatement to suggest that the optimal response of monetary and fiscal policy to the large movements in financial markets is not well understood. That this is so can be gathered by the sheer volume of space devoted over the last few years to academic contributions, policy papers and popular commentary in general. Unfocused academic research must shoulder some of the blame for this state of affairs and sadly there is still a remarkable lack of solid workhorse quantitative models than can be used for macroeconomic analysis in the presence of financial market frictions. Several of the theoretical underpinnings of financial crises have been fairly well understood for generations, and much world class theory has been done in the last 20 years. Unfortunately, much of it remains at a level of abstraction that reduces its usefulness for applied macroeconomics analysis which places a very high premium on specific quantitative implications. Thus, with the possible exception of Bernanke et al. (1999) and perhaps also Kiyotaki and Moore (1997) and Carlstrom and Fuerst (1997) it has proved difficult to capture the essential aspects of financial markets in a tractable quantifiable way. Moreover, although these models represent important early steps their limitations are also becoming rather too apparent to those wishing to use them in practical applications. Credit constraints may well be important, but it is hard to believe they can explain why leverage ratios rose so high between 2005 and 2008 or so. Aggregate data also suggests that an hypothetical aggregate firm of the type used in these models would have more than enough cash in its balance sheet not to depend very heavily on external resources if it so wished. Equally significant is the fact that recessions are often sharp and deep, particularly so in credit markets, and looking nothing like the smooth linear events produced by these simple aggregate models. Finally, and perhaps even more damaging is the fact that the entire transmission mechanism in these early models relies on grossly counterfactual patterns in asset markets, and generally ignores entirely the role to risk premia in the economy. Although not yet a fully developed alternative, this paper represents an attempt to develop a new framework that begins to address some of the shortcomings in the existing literature.1 It investigates the expected effect of monetary policy and expected inflation on corporate default and credit spreads. Although the current paper’s focus on the potential for debt deflations to exacerbate the effects of underlying real shocks is not new, the authors bring a much expanded set of tools that can be used to explicitly analyze the role of debt markets and prices on default decisions of firms and develop important policy implications. 2. Key model assumptions and discussion 2.1. Credit risk The basic setting combines elements from the new generation of credit risk models with classical staples from the monetary economics literature such as interest rate rules in a somewhat stylized equilibrium setting. General equilibrium links risk pricing to macro quantities and, in a monetary setting with nominal debt contracts, to monetary policy and interest rates. E-mail address: [email protected] Other recent papers offering new and richer insights into the role of financial markets in the macroeconomy include Brunnermeier and Sannikov (2010), Gertler and Kiyotaki (2010), Gilchrist et al. (2010), Gomes and Schmid (2010, 2011), Gourio (2010) and Jermann and Quadrini (2010). 1
0304-3932/$ - see front matter & 2011 Elsevier B.V. All rights reserved. doi:10.1016/j.jmoneco.2011.05.009
496
J.F. Gomes / Journal of Monetary Economics 58 (2011) 495–497
In its key features the equilibrium credit risk model is similar to that of Bhamra et al. (2010) and relies on the pricing of corporate credit by risk averse investors.2 The fundamental element is the assumption of endogenous default by equity holders, triggered by the excessive burden of debt relative to expected future cash flows. It is the nature of this optimal decision that will link bankruptcy losses to macroeconomic conditions in general and monetary policy in particular. Corporate credit takes the form of long-lived nominal bonds issued at the initial date of birth for the firm, and requiring regular coupon payments. Long-lived debt has various implications but it is very tractable because it removes the need to optimize periodically and makes it easier to keep tract of cross-sectional differences across firms. The long maturities add to the underlying risk of default and make it easier to generate plausible credit spreads, at least when compared with other models with one-period debt contracts. 2.2. Real business cycles and amplification mechanism The current paper does not consider corporate investment at all. Eliminating investment reduces the distance between consumption and output and greatly facilitates aggregation. This links consumption and (asset) prices more directly a result that is even more valuable here than in simpler monetary theory settings. A second very important benefit is that it again significantly reduces the complexity of the decisions facing firms in every period. Of course while this is a convenient simplification that is not without precedent in many recent monetary models it is clearly not ideal. Without firm level investment what generates cyclical fluctuations in output, besides the underlying exogenous shocks? In principle are two possibilities in these models. The first is cyclical entry and exit but the authors choose not to pursue this route too far by simply assuming that each exiting firm is simply replaced by a new entrant (or alternatively just reorganized).3 However, the current model easily generates countercyclical exit rates and a more developed framework that allows for endogenous entry would significantly enhance the ability of the credit mechanism outlined here to amplify shocks. The main mechanism employed here, however, is the fluctuation in aggregate losses due to credit defaults which are also markedly countercyclical. Although most of these investor losses are treated as pure redistribution across households a (very) small fraction are considered to be deadweight costs as a whole. The concentration of credit losses in recessions generates a potentially sharp drop in output and consumption, making these events look a lot more like the data. With endogenous investment (or firm entry) the worsening in expected credit losses would also make it more difficult to fund new projects or firms further denting short term economic growth.4 Moreover, the rise in consumption volatility leads to a potentially large (depending on preferences) increase in risk premia and significant widening in credit spreads which is also much more in line with the data. This effect is not discussed in the paper because it is probably small but its magnitude will depend on what is assumed for the value of the deadweight losses. The overall magnitude of these bankruptcy costs is a subject of considerable debate in the corporate finance literature, but the authors estimate of about 20% of asset value does not seem unreasonable. By generating large enough credit losses it allows them to obtain plausible values for credit spreads in the model, something that it is extremely hard to do in Bernanke et al. (1999). More controversial perhaps is the assumption of very low deadweight losses, although the evidence here is quite limited. The main consequence of calibrating the model to this low number is that it again severely limits the impact of any shocks on aggregate consumption and income over the cycle. In fact if these losses were entirely rebated, aggregate consumption and output would be not be endogenous at all in this model. Allowing for even a small amount of aggregate losses means that the equilibrium default rate, and thus the crosssectional heterogeneity in firms that determines it, will matter for the aggregate behavior of the economy. This is potentially a significant computational burden, and clearly something the authors try to minimize with their assumptions of ‘‘near-aggregation’’. In spite of these simplifications the nonlinearity of the optimal default decision in itself has one very important benefit: it allows the model to generate extremely asymmetric business cycles with very sharp recessions, characterized by large waves of corporate defaults. This is just one widely documented fact about credit markets that financial accelerator type models cannot address at all. 2.3. Monetary policy While the basic insights from the real fluctuations are quite similar to those in other recent papers the main novelty of the this work is its focus on monetary policy. As in new-keynesian models the link between monetary policy and real activity relies on nominal rigidities. Here, however, these rigidities take the form of long-lived corporate bonds that demand periodic nominal repayments. As discussed earlier this implies that rises in real interest rates will change the real burden of debt to firms and the incentives for corporate defaults. Because these in turn impact real output and aggregate consumption, sticky debt acts very much like sticky prices in classical monetary models. This is perhaps the core idea of the paper and one that perhaps should attract much more attention from future researchers. 2
Here, however, and presumably for tractability, these investors have standard power utility over real consumption. In practice exiting firms will on average be less productive that new entrants which draw their productivities from an unconditional distribution. However, this difference does not seem to play a major role in the findings. 4 See Gomes and Schmid (2010) for example. 3
J.F. Gomes / Journal of Monetary Economics 58 (2011) 495–497
497
To exploit these ideas the authors assume that monetary policy takes the form of a stochastic rule that links nominal interest rates to inflation, output and temporary monetary policy shocks. The important thing is that now both output and inflation will depend on aggregate default rates. This raises the issue of whether monetary policy should respond to credit market conditions and, more precisely what is the optimal monetary policy in this setting. The authors avoid a direct answer and chose instead to approach this issue with caution, by illustrating the consequences of different rules for economic performance following adverse shocks. These monetary policy exercises confirm our basic intuition that a debt deflation spiral follows when the central bank follows a passive nominal interest rate target. Again this is not really surprising, since as real interest rates are allowed to fluctuate the real burden of corporate debt moves as well and so do corporate defaults. As expected a more intelligent monetary policy that targets inflation can mitigate these effects, but the most important finding and possibly the main novelty in the paper is formalized in Proposition 1. This proposition establishes that (linear) inflation targeting also requires monetary policy to respond to credit market data. In the paper the authors focus on targeting aggregate default rates directly but it is much more likely, however, that a practical application would use a measure of credit spreads instead. Data on credit spreads is very easy to obtain and forward looking containing much information about expected future defaults probabilities and expected losses. This result is extremely important because it specifically shows the shortcomings of simple monetary policy rules that ignore financial market data. Conversely if shows how useful financial market data can be for policy makers attempting to forecast, and react to, expected economic performance. There is such a gap in this literature that it is difficult to anticipate the generality of this finding. It is obvious that the cross-sectional distribution of firms is an important state variable and that moments of that distribution, such as default rates, could be useful, to predict prices and quantities. But it is not clear at this stage what would be useful summary statistics for this and whether variables such as output and inflation would not be enough to mop up most of the relevant information. Crucial as this issue is, it must remain as an open question for future research. 3. Conclusion In a strange paradox the progressive rise of financial economics as a separate field has led to increasing neglect of finance as a subject by most macroeconomists, who prefer instead to concentrate on labor and goods market frictions alone. Surely this neglect is now at an end. The internet boom of the 1990s and now the financial crisis have made it increasingly difficult for macroeconomist to overlook the importance of financial markets to the economy as a whole. This paper is part of a renewed agenda to incorporate frontier developments in corporate finance and asset pricing into modern macroeconomic settings that are also suitable for policy analysis. It offers some important insights into what monetary policy might look like in a world with heterogeneous firms and optimal defaults. At this stage the model should be viewed as a suggestive illustration. The tension between allowing credit frictions to produce meaningful propagation mechanisms and preserving a modicum of computational tractability, undoubtedly limits its application but no more so than in so many other monetary policy models. References Bhamra, H., Kuehn, L.-A., Strebulaev, I., 2010. The aggregate dynamics of capital structure and macroeconomic risk. Review of Financial Studies 23 (12), 4187–4241. Bernanke, B., Gertler, M., Gilchrist, S., 1999. The financial accelerator in a quantitative business cycle framework. In: Woodford, M., Taylor, J. (Eds.), Handbook of Macroeconomics. North Holland. Brunnermeier, M., Sannikov, Y., 2010. A macroeconomic model with a financial sector. Working paper, Princeton University. Carlstrom, C., Fuerst, T., 1997. Agency costs, net worth, and business fluctuations: a computable general equilibrium analysis. American Economic Review 87 (5), 893–910. Gertler, M., Kiyotaki, N., 2010. Financial intermediation and credit policy in business cycle analysis. Working paper, Princeton University. Gilchrist, S., Yankov, V., Zakrajsek, E., 2010. Credit market shocks and economic fluctuations: evidence from corporate bond and stock markets. Working paper, Boston University. Gomes, J.F., Schmid, L., 2010. Equilibrium credit spreads and the macroeconomy. Working paper, Duke university. Gomes, J.F., Schmid, L., 2011. Credit sensitive monetary policy. Working paper, Duke University. Gourio, F., 2010. Credit risk and disaster risk. Working paper, Boston University. Jermann, U., Quadrini, V., 2010. Macroeconomic effects of financial shocks. Working paper, University of Pennsylvania. Kiyotaki, N., Moore, J., 1997. Credit cycles. Journal of Political Economy 105 (2), 211–248.