BIS Papers No 95 Frontiers of macrofinancial linkages by Stijn Claessens and M Ayhan Kose Monetary and Economic Department January 2018 The views expressed are those of the authors and not necessarily the views of the BIS. This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2018. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISSN 1609-0381 (print) ISBN 978-92-9259-123-6 (print) ISSN 1682-7651 (online) ISBN 978-92-9259-124-3 (online) “…They [economists] turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets – especially financial markets – that can cause the economy’s operating system to undergo sudden, unpredictable crashes …” Paul Krugman (2009a) ““Hello, Paul, where have you been for the last 30 years?”… Pretty much all we have been doing for 30 years is introducing flaws, frictions and new behaviors... The long literature on financial crises and banking … has also been doing exactly the same….” John H. Cochrane (2011a) “I believe that during the last financial crisis, macroeconomists (and I include myself among them) failed the country, and indeed the world. In September 2008, central bankers were in desperate need of a playbook that offered a systematic plan of attack to deal with fast evolving circumstances. Macroeconomics should have been able to provide that playbook. It could not…” Narayana Kocherlakota (2010) “… What does concern me of my discipline, however, is that its current core – by which I mainly mean the so-called dynamic stochastic general equilibrium (DSGE) approach – has become so mesmerized with its own internal logic… This is dangerous for both methodological and policy reasons… To be fair to our field, an enormous amount of work at the intersection of macroeconomics and corporate finance has been chasing many of the issues that played a central role during the current crisis… However, much of this literature belongs to the periphery of macroeconomics rather than to its core…” Ricardo Caballero (2010) “One can safely argue that there is a hole in our knowledge of macro financial interactions; one might also argue more controversially that economists have filled this hole with rocks as opposed to diamonds; but it is harder to argue that the hole is empty.” Ricardo Reis (2017) “The financial crisis … made it clear that the basic model, and even its DSGE cousins, had other serious problems, that the financial sector was much more central to macroeconomics than had been assumed...” Olivier Blanchard (2017a) BIS Papers No 95 iii Frontiers of macrofinancial linkages Stijn Claessens and M Ayhan Kose Foreword The Great Financial Crisis (GFC) of 2007–09 confirmed the vital importance of advancing our understanding of macrofinancial linkages. The GFC was a bitter reminder of how sharp fluctuations in asset prices, credit and capital flows can have a dramatic impact on the financial position of households, corporations and sovereign nations. These fluctuations were amplified by macrofinancial linkages, bringing the global financial system to the brink of collapse and leading to the deepest contraction in world output in more than half a century. Moreover, these linkages resulted in unprecedented challenges for fiscal, monetary and financial regulatory policies. Macrofinancial linkages centre on the two-way interactions between the real economy and the financial sector. Shocks arising in the real economy can be propagated through financial markets, thereby amplifying business cycles. Conversely, financial markets can be the source of shocks, which, in turn, can lead to more pronounced macroeconomic fluctuations. The global dimensions of these linkages can result in cross-border spillovers through both real and financial channels. The GFC revived an old debate in the economics profession about the importance of macrofinancial linkages. Some argue that the crisis was a painful reminder of our limited knowledge of these linkages. Others claim that the profession had already made substantial progress in understanding them but that there was too much emphasis on narrow approaches and modelling choices. Yet, most also recognise that the absence of a unifying framework to study these two-way interactions has limited the practical applications of existing knowledge and impeded the formulation of policies. We present a systematic review of the rapidly expanding literature on macrofinancial linkages to shed light on these debates. Two critical observations inform our review. First, a good understanding of macrofinancial linkages requires a strong grasp of the links between asset prices and macroeconomic outcomes. Second, since macrofinancial linkages often arise because of financial market Claessens (Monetary and Economic Department, Bank for International Settlements; CEPR; [email protected]); Kose (Development Prospects Group, World Bank; Brookings Institution; CEPR; CAMA; [email protected]). We are grateful to Olivier Blanchard for his helpful comments at the early stages of this project of surveying the literature on macrofinancial linkages when we were with the Research Department of the International Monetary Fund. We would like to thank Boragan Aruoba, Claudio Borio, Menzie Chinn, Ergys Islamaj, Jaime de Jesus Filho, Raju Huidrom, Atsushi Kawamoto, Seong Tae Kim, Grace Li, Raoul Minetti, Ezgi Ozturk, Eswar Prasad, Lucio Sarno, Hyun Song Shin, Kenneth Singleton, Naotaka Sugawara, Hui Tong, Kamil Yilmaz, Kei-Mu Yi, Boyang Zhang, Tianli Zhao, and many colleagues and participants at seminars and conferences for useful comments and inputs. Miyoko Asai, Ishita Dugar and Xinghao Gong provided excellent research assistance. Mark Felsenthal, Sonja Fritz, Krista Hughes, Serge Jeanneau, Graeme Littler, Tracey Lookadoo, Hazel Macadangdang and Rosalie Singson provided outstanding editorial help. The views expressed are those of the authors and do not necessarily represent those of the institutions they are affiliated with or have been affiliated with. BIS Papers No 95 v imperfections, it is necessary to understand the implications of such imperfections for macroeconomic outcomes. With these observations in mind, we first survey the literature on the linkages between asset prices and macroeconomic outcomes. We then review the literature on the macroeconomic implications of financial imperfections. We also examine the global dimensions of macrofinancial linkages and document the main stylized facts about the linkages between the real economy and the financial sector. The topic of macrofinancial linkages promises to remain an exciting area of research, given the many open questions and significant policy interest. We conclude our survey with a discussion of possible directions for future research, stressing the need for richer theoretical models, more robust empirical work and better quality data so as to advance knowledge and help guide policymakers going forward. vi BIS Papers No 95 Table of contents Foreword ...................................................................................................................................................... v 1. Introduction ....................................................................................................................................... 1 2. Asset prices and macroeconomic outcomes ........................................................................ 8 2.1 Linkages between asset prices and macroeconomic outcomes ........................ 8 2.2 Understanding asset prices and macroeconomic outcomes ............................ 12 A. Basic mechanisms ...................................................................................................... 13 B. Empirical evidence ..................................................................................................... 16 C. Challenges to the standard models .................................................................... 22 2.3 International dimensions of asset prices ................................................................... 28 A. Determination of asset prices in open economy models .......................... 28 B. Empirical evidence ..................................................................................................... 29 C. International dimensions of asset pricing puzzles ........................................ 33 2.4 Exchange rates and macroeconomic outcomes ..................................................... 35 A. Basic mechanisms ...................................................................................................... 35 B. Empirical evidence ..................................................................................................... 39 C. Exchange rate puzzles .............................................................................................. 44 2.5 Interest rates and macroeconomic outcomes ......................................................... 50 A. Basic mechanisms ...................................................................................................... 50 B. Empirical evidence ..................................................................................................... 51 C. Challenges to the standard models .................................................................... 56 2.6 Taking stock .........................................................................................................................