The global financial crisis has served as a powerful reminder that large credit and asset price booms often end in busts (Reinhart and Rogoff 2009). The ensuing financial turmoil has overwhelmed the capacity of governments to stem the economic slump through counter-cyclical fiscal or monetary responses. This grim outcome flies in the face of what used to be the received wisdom on how central banks should handle bubbles – namely, let them rip and concentrate on “mopping up after a crisis” (Greenspan 1997).
Brunnermeier et al. (2009), among others, has proposed counter-cyclical capital regulations on financial institutions that require them to hold higher reserves during booms, which would give them a larger capital buffer to absorb losses in the event of a bust. In September 2010, the Basel Committee on Banking Supervision (2010) agreed on a framework to impose counter-cyclical capital requirements that may range from zero during busts to 2.5% during booms.
At first blush it might seem obvious that we would want to regulate and curtail the volatility created by recurrent booms and busts in credit and asset prices. However, devoted free-marketeers could argue that the invisible hand of the market knows best how to allocate capital in the economy. If market participants choose to take on large amounts of credit in the face of an asset price boom, the argument goes, then it is optimal to let them do so – they are taking a calculated risk, and preventing them from doing so would make them worse off.
Collateralised borrowing and externalities: New evidence
In recent research (Jeanne and Korinek 2010), we explain why the free-marketeers’ argument may not hold. We show that the existence of collateralised borrowing gives rise to an externality, i.e. a market imperfection that explains why the free-market equilibrium exhibits too much volatility and why government regulation is in fact desirable and can make everybody in the economy better off. When credit is collateralised, the interaction between debt accumulation and asset prices contributes to magnify the impact of booms and busts. Increases in borrowing and in collateral prices feed each other during booms. In busts, the feedback turns negative, with credit constraints leading to fire sales of assets and further tightening of credit.
Specifically, when borrowers in a given sector use an asset as collateral, then their borrowing capacity is an increasing function of the price of the asset. The price of the asset, in turn, is driven by the sector's demand for assets, which depends on their borrowing capacity. This introduces a mutual feedback loop between asset prices and credit flows: small financial shocks to the sector can lead to large simultaneous booms or busts in asset prices and credit flows (see Figure 1).
Figure 1. Feedback loops
The lessons from this theory can be applied to a number of economic settings in which the systemic interaction between credit and asset prices is important. The sector could be interpreted as a group of entrepreneurs who have more expertise than outsiders to operate a productive asset, or as households who own durable consumer assets or their homes. Alternatively, the sector could represent a group of investors who enjoy an advantage in dealing with a certain class of financial assets and borrow against them, for example because of superior information or superior risk management skills.
In Jeanne and Korinek (2010), we show that the asset-debt loop entails systemic externalities that lead borrowers to undervalue the benefits of conserving liquidity as a precaution against busts. A borrower who holds more liquidity (or equivalently less debt) when the economy experiences a bust, relaxes not only his private collateral constraint but also the collateral constraints of all other borrowers because he does not have to fire-sell his asset holdings, thereby supporting the asset price.
Since individual borrowers do not internalise this spill-over effect, they take on too much debt during good times. We find that it would be optimal for policymakers to impose countercyclical regulatory measures on leveraged borrowing to prevent borrowers from taking on socially excessive levels of debt. Macroprudential regulation should be tightened in booms as borrowers increase their leverage and as the vulnerability of the economy to a bust grows – and reduced in busts, when lenders recall their loans and leverage in the economy declines.
The objective of such regulatory measures is to raise the private cost of borrowing to the social cost, i.e. to induce borrowers to internalise the negative externalities that they impose on the economy by borrowing excessively. It is therefore convenient to express the magnitude of the measure as a “Pigouvian tax,” i.e. a tax that captures the external costs that borrowers impose on the economy. In practice, such a policy measure can be implemented through capital adequacy requirements or through similar regulatory measures. In Figure 2, we show how the optimal tax evolves over time in a version of the model that is calibrated to fit the US small-and-medium-sized enterprise sector. In the example, we assumed that the economy experiences a bust in time periods 15 and 22.
Figure 2. The optimal Pigouvian tax on debt in the US small and medium enterprise sector
The optimal magnitude of the Pigouvian tax depends on the vulnerability to a fall in collateral prices of the borrowers in a given sector (see Figure 3). In the calibration of our model to the US small-and-medium-sized enterprise sector, we found that the optimal macroprudential tax (or equivalent measure) on debt converges to 0.56% of the amount of debt outstanding over the course of a boom. Borrowing by the US household sector is subject to externalities of similar magnitude (0.48% in booms). By contrast, US Flow of Funds data over the past decade suggest that large corporations that have access to corporate bond markets were less subject to systemic externalities and did not require the same type of macro-prudential measures.
Figure 3. Optimal macroprudential tax during booms in three US sectors
The optimal tax should also be adapted to the maturity of debt. Long-term debt makes the economy less vulnerable to busts than short-term debt, because lenders cannot immediately recall their loans when the value of collateral assets declines. For example, 30-year mortgages make the economy less prone to busts than mortgages with teaser rates that are meant to be refinanced after a short period of time.
An important benefit of ex-ante prudential taxation during booms is that it avoids the moral hazard problems associated with bailouts. When borrowers expect to receive bailouts in the event of systemic crises, they have additional incentives to take on debt. If the financial regulators accumulate a bailout fund, borrowers may increase their indebtedness in equal measure, leading to a form of “bailout neutrality” (see also Korinek 2009).
Basel Committee on Banking Supervision (2010), Countercyclical Capital Buffer Proposal, BCBS Consultative Document, Basel, July 2010.
Brunnermeier, Markus K, Andrew Crockett , Charles A Goodhart , Avinash Persaud and Hyun Song Shin (2009), The Fundamental Principles of Financial Regulation, Geneva Report on the World Economy, July 2009.
Greenspan, Alan (1997). Testimony to US Congress, as reported in New York Times, 5 March 1997.
Jeanne, Olivier and Anton Korinek (2010), "Managing Credit Booms and Busts: A Pigouvian Taxation Perspective", CEPR Discussion Paper 8015.
Korinek, Anton (2009), "Systemic Risk-Taking: Amplification Effects, Externalities, and Regulatory Responses", working paper, University of Maryland.
Reinhart, Carmen M. and Kenneth Rogoff (2009), This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press.