Guido Lorenzoni

Credit Crises, Precautionary Savings, and the Liquidity Trap

We use a model a la Bewly-Huggett-Ayagari to explore the effects of a credit crunch on consumer spending. Households borrow and lend to smooth idiosyncratic income shocks facing an exogenous borrowing constraint. We look at the economy response after an unexpected permananent tightening of this constraint. The interest rate drops sharply in the short run and then adjusts to a lower steady state level. This is due to the fact that after the shock a large fraction of agents is far below their target holdings of precautionary savings and this generates a large temporary positive shock to net lending. We then look at the effects on output. Here two opposing forces are present, as households can deleverage in two ways: by consuming less and by working more. We show that under a reasonable parametrization the effect on consumer spending dominates and precautionary behavior generates a recession. If we add nominal rigidities two things happen: (i) the demand-side dominates output dynamics, and (ii) there is a lower bound on the interest rate adjustment. These two elements tend to amplify the recession caused by the credit tightening.

Slow Moving Debt Crises

What circumstances or policies leave sovereign borrowers at the mercy of self-fulfilling increases in interest rates? To answer this question, we study the dynamics of debt and interest rates in a model where default is driven by insolvency. Fiscal deficits and surpluses are subject to shocks but influenced by a fiscal policy rule. Whenever possible the government issues debt to meet its current obligations and defaults otherwise. We show that low and high interest rate equilibria may coexist. Higher interest rates, prompted by fears of default, lead to faster debt accumulation, validating default fears. We call such an equilibrium a slow moving crisis, in contrast to rollover crises where investor runs precipitate immediate default. We investigate how the existence of multiple equilibria is affected by the fiscal policy rule, the maturity of debt, and the level of debt.

Bubbles and Self‐Enforcing Debt

We characterize equilibria with endogenous debt constraints for a general equilibrium economy with limited commitment in which the only consequence of default is losing the ability to borrow in future periods. First, we show that equilibrium debt limits must satisfy a simple condition that allows agents to exactly roll over existing debt period by period. Second, we provide an equivalence result, whereby the resulting set of equilibrium allocations with self-enforcing private debt is equivalent to the allocations that are sustained with unbacked public debt or rational bubbles; for the latter, there exist well known existence and characterization results. In contrast to the classic result by Bulow and Rogoff (AER 1989), positive levels of debt are sustainable in our environment because the interest rate is sufficiently low to provide repayment incentives.

Decentralized trading with private information

The paper studies how asset prices are determined in a decentralized market with asymmetric information about asset values. We consider an economy in which a large number of agents trade two assets in bilateral meetings. A fraction of the agents has private information about the asset values. We show that, over time, uninformed agents can elicit information from their trading partners by making small offers. This form of experimentation allows the uninformed agents to acquire information as long as there are potential gains from trade in the economy. As a consequence, the economy converges to a Pareto efficient allocation.

Financial Integration and Liquidity Crises

The paper analyzes the effects of financial integration on the stability of the banking system. Financial integration allows banks in different regions to smooth local liquidity shocks by borrowing and lending on a world interbank market. We show under which conditions financial integration induces banks to reduce their liquidity holdings and to shift their portfolios towards more profitable but less liquid investments. Integration helps reallocate liquidity when different banks are hit by uncorrelated shocks. However, when a correlated (systemic) shock hits, the total liquid resources in the banking system are lower than in autarky. Therefore, financial integration leads to more stable interbank interest rates in normal times, but to larger interest rate spikes in crises. These results hold in a setup where financial integration is welfare improving from an ex ante point of view. We also look at the models implications for financial regulation and show that, in a second-best world, financial integration can increase the welfare benefits of liquidity requirements.

International Financial Crises

This chapter surveys recent research on international financial crises. A financial crisis is characterized by a sudden, dramatic outflow of financial resources from an economy with an open capital account. This outflow may be primarily driven by the expectation of a large nominal devaluation, in a situation in which the domestic monetary-fiscal regime appears inconsistent with a fixed exchange rate. Or the outflow may be driven by a reallocation of funds by foreign and domestic investors, due to a changed perception in the country’s growth prospects, to an increase in the risk of domestic default, or to a shift in investors’ attitudes toward risk. Often times, monetary and financial elements are combined. A drop in domestic asset prices and in the real exchange rate can act as powerful amplifiers of the real effects of the crisis, through adverse balance-sheet adjustments. The chapter surveys research that looks both at the monetary and at the financial side of crises, also discussing work that investigates the accumulation of imbalances preceding the crisis and the scope for preventive policies.

Moral Hazard Misconceptions: the Case of the Greenspan Put

Policy discussions on financial regulation tend to assume that whenever a corrective policy is used ex post to ameliorate the effects of a crisis, there are negative side effects in terms of moral hazard ex ante. This paper shows that this is not a general theoretical prediction, focusing on the case of monetary policy interventions ex post. In particular, we show that if the central bank does not intervene by monetary easing following a crisis, an aggregate demand externality makes borrowing ex ante inefficient. If instead the central bank follows the optimal discretionary policy and intervenes to stabilize asset prices and real activity, we show examples in which the aggregate demand externality disappears, reducing the need for ex ante intervention.

Financial Crises, Dollarization, and Lending of Last Resort in Open Economies

Foreign currency borrowing is perceived as a source of financial instability in emerging markets. We propose a theory where liability dollarization arises from an insurance motive of domestic savers. Because financial crises are associated with currency depreciations, savers are reluctant to hold assets denominated in local currency. This behavior makes local currency debt expensive, incentivizing borrowers to issue foreign currency debt. We show that this mechanism can generate multiple equilibria, with the bad equilibrium characterized by dollarization and financial instability. A domestic lender of last resort can eliminate the bad equilibrium, but interventions need to be fiscally credible. Holdings of foreign currency reserves hedge the fiscal position of the government and enhance its credibility, thus improving financial stability. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.