Markus K. Brunnermeier

Deciphering the Liquidity and Credit Crunch 2007-2008

This paper summarizes and explains the main events of the liquidity and credit crunch in 2007-08. Starting with the trends leading up to the crisis, I explain how these events unfolded and how four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets.

Bubbles and Crashes

We present a model in which an asset bubble can persist despite the presence of rational arbitrageurs. The resilience of the bubble stems from the inability of arbitrageurs to temporarily coordinate their selling strategies. This synchronization problem together with the individual incentive to time the market results in the persistence of bubbles over a substantial period of time. Since the derived trading equilibrium is unique, our model rationalizes the existence of bubbles in a strong sense. The model also provides a natural setting in which public events, by enabling synchronization, can have a disproportionate impact relative to their intrinsic informational content.

A Macroeconomic Model with a Financial Sector

This paper studies the full equilibrium dynamics of an economy with financial frictions. Due to highly non-linear amplification effects, the economy is prone to instability and occasionally enters volatile episodes. Risk is endogenous and asset price correlations are high in down turns. In an environment of low exogenous risk experts assume higher leverage making the system more prone to systemic volatility spikes - a volatility paradox. Securitization and derivatives contracts leads to better sharing of exogenous risk but to higher endogenous systemic risk. Financial experts may impose a negative externality on each other and the economy by not maintaining adequate capital cushion.

Carry Trades and Currency Crashes

This paper documents that carry traders are subject to crash risk: i.e. exchange rate movements between high-interest-rate and low-interest-rate currencies are negatively skewed. We argue that this negative skewness is due to sudden unwinding of carry trades, which tend to occur in periods in which risk appetite and funding liquidity decrease. Funding liquidity measures predict exchange rate movements, and controlling for liquidity helps explain the uncovered interest-rate puzzle. Carry-trade losses reduce future crash risk, but increase the price of crash risk. We also document excess co-movement among currencies with similar interest rate. Our findings are consistent with a model in which carry traders are subject to funding liquidity constraints.

Synchronization risk and delayed arbitrage

We argue that arbitrage is limited if rational traders face uncertainty about when their peers will exploit a common arbitrage opportunity. This synchronization risk—which is distinct from noise trader risk and fundamental risk—arises in our model because arbitrageurs become sequentially aware of mispricing and they incur holding costs. We show that rational arbitrageurs ‘‘time the market’’ rather than correct mispricing right away. This leads to delayed arbitrage. The analysis suggests that behavioral influences on prices are resistant to arbitrage in the short and intermediate run. r 2002 Elsevier Science B.V. All rights reserved.

Macroeconomics with Financial Frictions: A Survey

This article surveys the macroeconomic implications of financial frictions. Financial frictions lead to persistence and when combined with illiquidity to non-linear amplification effects. Risk is endogenous and liquidity spirals cause financial instability. Increasing margins further restrict leverage and exacerbate downturns. A demand for liquid assets and a role for money emerges. The market outcome is generically not even constrained efficient and the issuance of government debt can lead to a Pareto improvement. While financial institutions can mitigate frictions, they introduce additional fragility and through their erratic money creation harm price stability.

Computational complexity and information asymmetry in financial products

This paper introduces notions from computational complexity into the study of financial derivatives. Traditional economics argues that derivatives, like CDOs and CDSs, ameliorate the negative costs imposed due to asymmetric information between buyers and sellers. This is because securitization via these derivatives allows the informed party to find buyers for the information-insensitive part of the cash flow stream of an asset (e.g., a mortgage) and retain the remainder. In this paper we show that this viewpoint may need to be revised once computational complexity is brought into the picture. Assuming reasonable complexity-theoretic conjectures, we show that derivatives can actually amplify the costs of asymmetric information instead of reducing them. We prove our results both in the worst-case setting, as well as the more realistic average case setting. In the latter case, to argue that our constructions result in derivatives that “look like” real-life derivatives, we use the notion of computational indistinguishability a la cryptography.

Clock games: Theory and experiments

Timing is crucial in situations ranging from currency attacks, to product introductions, to starting a revolution. These settings share the feature that payo®s depend critically on the timing of a few other key players—and their moves are uncertain. To capture this, we introduce the notion of clock games and experimentally test them. Each player’s clock starts on receiving a signal about a payo® relevant state variable. Since the timing of the signals is random, clocks are de-synchronized. A player must decide how long, if at all, to delay his move after receiving the signal. We show that (i) equilibrium is always characterized by strategic delay—regardless of whether moves are observable or not; (ii) delay decreases as clocks become more synchronized and increases as information becomes more concentrated; (iii) When moves are observable, players “herd” immediately after any player makes a move. We then show, in a series of experiments, that key predictions of the model are consistent with observed behavior.

Leadership, Coordination and Mission-Driven Management

What makes a good leader? A good leader is able to coordinate his followers around a credible mission statement, which communicates the future course of action of the organization. In practice, leaders learn about the best course of action for the organization over time. While learning helps improve the organizations goals it also creates a time-consistency problem. Leader resoluteness is a valuable attribute in such a setting, since it slows down the leaders learning and thus improves the credibility of the mission statement. But resolute leaders also inhibit communication with followers and leader resoluteness is costly when followers have sufficiently valuable signals.

Liquidity Mismatch Measurement

The purpose of this paper is to examine the measurement of liquidity in light of the academic research on liquidity. We present a theoretical liquidity measure, informed by the academic literature on liquidity, and analyze its benefits in terms of assessing liquidity risk both from a firm and macro-prudential perspective.