Research

Working Paper
Brunnermeier, Markus K, and Yuliy Sannikov. “The I Theory of Money”. Working Paper: n. pag. Print.Abstract
A theory of money needs a proper place for financial intermediaries. Intermediaries create money by taking deposits from savers and investing them in productive projects. The money multiplier depends on the size of intermediary balance sheets, and their ability to take risks. In downturns, as lending contracts and the money multiplier shrinks, the value of money rises. This leads to a Fisher deflation that hurts borrowers and amplifies shocks. An accommodative monetary policy in downturns, focused on the assets held by constrained agents, can mitigate these destabilizing adverse feedback effects. We devote particular attention to interest rate cuts, and study the potential for such policies to create moral hazard.
i_theory05.pdf
In Preparation
Brunnermeier, Markus K, Michael Sockin, and Wei Xiong. “China's Model of Managing the Financial System”. (In Preparation). Print.
Brunnermeier, Markus K, and Valentin Haddad. “Safe Assets”. (In Preparation). Print.
Brunnermeier, Markus K, and Ricardo Reis. “A Crash Course on the Euro Crisis”. (In Preparation). Print.Abstract
This paper provides a template for teaching the Euro crisis. It starts by stressing the importance of international capital flows that primarily fueled sectors with low productivity in the periphery. A key element of the crisis is that international capital flows were intermediated by banks and that most European banks rely heavily on less stable short-term wholesale funding. A sudden stop of this funding flows leads to fire-sales and a credit crunch. This is worsened by the ''diabolic loop'' between sovereign and banking risk. The paper addresses various liquidity policy measures and argues that insolvency issues are not addressed since fiscal authorities and monetary authority play a game of chicken about who should absorb the losses.
01b EuroCrashCourse_slides.pdf
Submitted
Brunnermeier, Markus K, Gang Dong, and Darius Palia. “

Banks' Non-Interest Income and Systemic Risk

”. Submitted: n. pag. Print.Abstract
This paper documents that banks with higher non-interest income (noncore activities like investment banking, venture capital and trading activities) have a higher contribution to systemic risk than traditional banking (deposit taking and lending). After decomposing total non-interest income into two components, trading income and investment banking and venture capital income, we find that both components are roughly equally related to systemic risk. These results are robust to endogeneity concerns when we use a difference-in-difference approach with the Lehman bankruptcy proxying for an exogenous shock. We also find that banks with higher trading income one-year prior to the recession earned lower returns during the recession period. No such significant effect was found for investment banking and venture capital income.
Banks and Systemic Risk
Brunnermeier, Markus K, and Patrick Cheridito. “

Measuring and Allocating Systemic Risk

”. Submitted: n. pag. Print.Abstract
This paper develops a framework for measuring, allocating and managing systemic risk. SystRisk, our measure of total systemic risk captures the a priori cost to society for providing tail-risk insurance to the financial system. Our allocation principle distributes the total systemic risk among individual institutions according to their size-shifted marginal contributions. To describe economic shocks and systemic feedback effects we propose a reduced form stochastic model that can be calibrated to historical data. We also discuss systemic risk limits, systemic risk charges and a cap and trade system for systemic risk.
Systrisk.pdf
Arora, Sanjeev, et al.

Computational Complexity and Information Asymmetry in Financial Products

”. Submitted: n. pag. Print.Abstract
Traditional economics argues that financial derivatives, like CDOs and CDSs, ameliorate the negative costs imposed by asymmetric information. This is because securitization via derivatives allows the informed party to find buyers for less information-sensitive 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. Using methods from theoretical computer science this paper shows that derivatives can actually amplify the costs of asymmetric information instead of reducing them. Note that computational complexity is only a small departure from full rationality since even highly sophisticated investors are boundedly rational due to a lack of requisite computational resources.
Complexity and Derivatives.pdf
Forthcoming
Macro, Money and Finance: A Continuous-Time Approach
Brunnermeier, Markus K, and Yuliy Sannikov. “Macro, Money and Finance: A Continuous-Time Approach”. Handbook of Macroeconomics. Forthcoming. Print.Abstract
This paper puts forward a manual for how to set up and solve a continuous time model that allows to analyze endogenous (1) level and risk dynamics. The latter includes (2) tail risk and crisis probability as well as (3) the Volatility Paradox. Concepts such as (4) illiquidity and liquidity mismatch, (5) endogenous leverage, (6) the Paradox of Prudence, (7) undercapitalized sectors (8) time-varying risk premia, and (9) the external funding premium are part of the analysis. Financial frictions also give rise to an endogenous (10) value of money.
_macrohandbook_brusan.pdf
2016
Adrian, Tobias, and Markus K Brunnermeier. “Co Va R”. American Economic Review 106.7 (2016): 1705-1741. Web. Publisher's VersionAbstract
We propose a measure for systemic risk, \Delta-CoVaR, defined as the conditional value at risk CoVaR of the financial system conditional on institutions being under distress in excess of the CoVaR of the system conditional on the median state of the institution. From our estimates of Delta-CoVaR for the universe of publicly traded financial institutions, we quantify the extent to which characteristics such as leverage, size, maturity mismatch, and asset price booms predict systemic risk contribution. We also provide out-of-sample forecasts of a countercyclical, forward-looking measure of systemic risk and show that the 2006Q4 value of this measure would have predicted more than one third of realized \Delta-CoVaR during the financial crisis.
CoVaR Slides.pdf CoVaR.pdf Code&Data.zip
Predicting and measuring a financial institution's contribution to systemic risk that internalizes externalities and avoids procyclicality.
Brunnermeier, Markus K, and Yuliy Sannikov. “On the Optimal Inflation Rate”. American Economic Review Papers and Proceedings 106.5 (2016): 484-489. Print.Abstract
In our incomplete markets economy households choose portfolios consisting of risky (uninsurable) capital and money. Money is a bubble, it has positive value even though it yields no payoff. The market outcome is constrained Pareto inefficient due to a pecuniary externality. Each individual agent takes the real interest rate as given, while in the aggregate it is driven by the economic growth rate, which in turn depends on individual portfolio decisions. Higher inflation due to higher money growth lowers the real interest rate (on money) and tilts the portfolio choice towards physical capital investment. Modest inflation boosts growth rate and welfare.
OptimalInflationRate.pdf OptimalInflationRate slides.pdf
Brunnermeier, Markus K, et al.The Sovereign-Banking Diabolic Loop and E S Bies”. American Economic Review Papers and Proceedings 106.5 (2016): 508-512. Print.Abstract
We propose a simple model of the sovereign-bank diabolic loop, and establish four results. First, the diabolic loop can be avoided by restricting banks’ domestic sovereign exposures relative to their equity. Second, equity requirements can be lowered if banks only hold senior domestic sovereign debt. Third, such requirements shrink even further if banks only hold the senior tranche of an internationally diversified sovereign portfolio – known as ESBies in the euro-area context. Finally, ESBies generate more safe assets than domestic debt tranching alone; and, insofar as the diabolic loop is defused, the junior tranche generated by the securitization is itself risk-free.
DiabolicLoop.pdf DiabolicLoop slides.pdf
The Euro and the Battle of Ideas
Brunnermeier, Markus K, Harold James, and Jean-Pierre Landau. The Euro and the Battle of Ideas. Princeton, NJ, USA: Princeton University Press, 2016. Web. Chapter 1:
Endorsements by Larry Summers (former US Treasury Secretary), Ben Bernanke (former Chairman of the US Fed), Wolfgang Schäuble (German Finance Minister) and Jean Tirole (Nobel Prize Laureate)
Bubbles and Central Banks: Historical Perspectives
Brunnermeier, Markus K, and Isabel Schnabel. “Bubbles and Central Banks: Historical Perspectives”. Central Banks at a Crossroads: What Can We Learn from History? . Cambridge, UK: Cambridge University Press, 2016. Web. Publisher's VersionAbstract
This paper reviews some of the most prominent asset price bubbles from the past 400 years and documents how central banks (or other institutions) reacted to those bubbles. The historical evidence suggests that the emergence of bubbles is often preceded or accompanied by an expansionary monetary policy, lending booms, capital inflows, and financial innovation or deregulation. We find that the severity of the economic crisis following the bursting of a bubble is less linked to the type of asset than to the financing of the bubble – crises are most severe when they are accompanied by a lending boom, high leverage of market players, and when financial institutions themselves are participating in the buying frenzy. Past experience also suggests that a purely passive “cleaning up the mess” stance towards inflating bubbles in many cases is costly. At the same time, while interest-rate leaning policies and macroprudential tools can and sometimes have helped to deflate bubbles and mitigate the associated economic crises, the correct implementation of such proactive policy approaches remains fraught with difficulties.
Bubbles_CentralBanks_Historical.pdf Bubbles_CentralBanks slides.pdf
Brunnermeier, Markus K, Filippos Papakonstantinou, and Jonathan A Parker. “Optimal Time-Inconsistent Beliefs: Misplanning, Procrastination, and Commitment”. Management Science (2016). Print.Abstract
We develop a structural theory of beliefs and behavior, that relaxes the assumption of time-consistency in beliefs. Our theory is based on the trade-off between optimism, which raises anticipatory utility, and objectivity, which promotes efficient actions. We present it in the context of allocating work on a project over time, develop testable implications to contrast it with models assuming time-inconsistent preferences, and compare its predictions to existing evidence on behavior and beliefs. Our predictions are: (i) optimal beliefs are optimistic and time-inconsistent; (ii) people optimally exhibit the planning fallacy; (iii) incentives for rapid task completion make beliefs more optimistic and worsen work smoothing, while incentives for accurate duration prediction make beliefs less optimistic and improve work smoothing; (iv) without a commitment device, beliefs become less optimistic over time; (v) in the presence of a commitment device, beliefs may become more optimistic over time, and people optimally exhibit preference for commitment.
Time-inconsistent Beliefs.pdf
2015
Brunnermeier, Markus K, and Yuliy Sannikov. “International Credit Flows and Pecuniary Externalities”. American Economic Journal: Macroeconomics 7.1 (2015): 297-338. Print.Abstract
This paper develops a dynamic two-country neoclassical stochastic growth model with incomplete markets. Short-term credit flows can be excessive and reverse suddenly. The equilibrium outcome is constrained inefficient. First, an undercapitalized country borrows too much since each individual firm does not internalize that an increase in production capacity undermines their output price and thereby worsens their terms of trade. From an ex-ante perspective each firm undermines the natural \lq\lq{}terms of trade hedge.\rq\rq{} Second, sudden stops and fire sales lead to sharp price drops of illiquid physical capital, another pecuniary externality. The analysis also provides a full characterization of the endogenous volatility dynamics and welfare. Imposing capital controls or other domestic macro-prudential policy measures that limit short-term borrowing can improve welfare.
InternationalCreditFlows.pdf InternationalCreditFlows_slides.pdf
2014
Brunnermeier, Markus K, and Yuliy Sannikov. “Monetary Analysis: Price and Financial Stability”. Ecb Forum on Central Banking. Sintra, Portugal, 2014. Print.Abstract
In a world with self-generated, endogenous risk and time-varying risk premia, price stability and financial stability are inseparable. A monetary analysis based on the distribution of liquidity mismatch across sectors provides valuable information about the build-up of vulnerabilities in tranquil times and helps to identify balance sheet impaired sectors in volatile times. When the monetary transmission mechanism becomes “sectorially impaired”, monetary policy action dis-proportionally favors issuers of government and large corporation debt over small and median enterprises (SMEs). Reviving a prudently designed asset backed securitization market for SME and consumer loans would alleviate this discrepancy and establish a pan European intermediation market.
05c ECB Sintra BruSan.pdf
Brunnermeier, Markus K, and Martin Oehmke. “Predatory Short Selling”. Review of Finance 18.6 (2014): 2153-2195. Web. Publisher's VersionAbstract
Financial institutions may be vulnerable to predatory short selling. Whenthe stock of a financial institution is shorted aggressively, leverage constraints imposed by short-term creditors can force the institution to liquidate long-term investments at fire sale prices. For financial institutions that are sufficiently close to their leverage constraints, predatory short selling equilibria co-exist with no-liquidation equilibria (the vulnerability region) or may even be the unique equilibrium outcome (the doomed region). Increased coordination among short sellers expands the doomed region, where liquidation is the unique equilibrium. Our model provides a potential justification for temporary restrictions on short selling of vulnerable institutions and can be used to assess recent empirical evidence on short-sale bans.
Predatory Short Selling.pdf
Winner of Pagano-Zechner Prize
Brunnermeier, Markus K, Gary Gorton, and Arvind Krishnamurthy. “

Liquidity Mismatch

”. Risk Topography. Chicago: University of Chicago Press, 2014. Print. liquidity_mismatch_slides.pdf Liquidity Mismatch.pdf
Brunnermeier, Markus K, Alp Simsek, and Wei Xiong. “A Welfare Criterion for Models with Biased Beliefs”. Quarterly Journal of Economics 129.4 (2014): 1711-1752. Print.Abstract
This paper proposes a welfare criterion for economies in which agents have heterogeneously distorted beliefs. Instead of taking a stand on whose belief is correct, our criterion asserts an allocation to be belief-neutral inefficient if it is inefficient under any convex combination of agents' beliefs. While this criterion gives an incomplete ranking of social allocations, it can identify negative-sum speculation in a broad range of prominent models with distorted beliefs.
Welfare Biased Beliefs Slides.pdf Welfare Biased Beliefs.pdf
Brunnermeier, Markus K, and Yuliy Sannikov. “

A Macroeconomic Model with a Financial Sector

”. American Economic Review 104.2 (2014): 379-421. Print.Abstract
This paper studies the full equilibrium dynamics of an economy with financial frictions. Due to highly nonlinear amplification effects, the economy is prone to instability and occasionally enters volatile crisis episodes. Endogenous risk, driven by asset illiquidity, persists in crisis even for very low levels of exogenous risk. This phenomenon, which we call the volatility paradox, resolves the Kocherlakota (2000) critique. Endogenous leverage determines the distance to crisis. Securitization and derivatives contracts that improve risk sharing may lead to higher leverage and more frequent crises.
macro_finance_slides.pdf macro_finance.pdf Readme for Matlab code.pdf
2013
Brunnermeier, Markus K, and Yuliy Sannikov. “

Redistributive Monetary Policy

”. Jackson Hole Symposium 2013331-384. Web. Publisher's VersionAbstract
Liquidity and deflationary spirals self-generate endogenous risk and redistribute wealth. Monetary policy can mitigate these effects and help rebalance wealth after an adverse shock, thereby reducing endogenous risk, stabilizing the economy, and stimulating growth. The redistributive channel differs from the classic Keynesian interest rate channel in models with price stickiness. Central banks assume and redistribute tail risk when purchasing assets or relaxing their collateral requirements. Monetary policy (rules) can be seen as a social insurance scheme for an economy beset by financial frictions. As with any insurance, it carries the cost of moral hazard. Redistributive monetary policy should be strictly limited to undoing the redistribution caused by the amplification effects and by moral hazard considerations.
Jackson Hole 2012 Presentation.pdf Redistributive Monetary Policy.pdf Three Stability Concepts.pdf
http://www.kansascityfed.org/publicat/sympos/2012/Brun_Sannikov_final.pdf
Brunnermeier, Markus K, and Yuliy Sannikov. “

Reviving Money and Banking

”. Is Inflation Targeting Dead?. VoxEU, 2013. Print.
Bubbles, Financial Crises, and Systemic Risk
Brunnermeier, Markus K, and Martin Oehmke. “

Bubbles, Financial Crises, and Systemic Risk

”. Handbook of the Economics of Finance. Amsterdam: Elsevier, 2013. Print.Abstract
This chapter surveys the literature on bubbles, financial crises, and systemic risk. The first part of the chapter provides a brief historical account of bubbles and financial crisis. The second part of the chapter gives a structured overview of the literature on financial bubbles. The third part of the chapter discusses the literatures on financial crises and systemic risk, with particular emphasis on amplification and propagation mechanisms during financial crises, and the measurement of systemic risk. Finally, we point toward some questions for future research.
Bubbles, Financial Crisis and Systemic Risk.pdf
Macroeconomics with Financial Frictions: A Survey
Brunnermeier, Markus K, Thomas Eisenbach, and Yuliy Sannikov. “

Macroeconomics with Financial Frictions: A Survey

”. Advances in Economics and Econometrics, Tenth World Congress of the Econometric Society. New York: Cambridge University Press, 2013. Print.Abstract
This article surveys the macroeconomic implications of financial frictions. Financial frictions lead to persistence and when combined with illiquidity to non-linear amplification e ects. Risk is endogenous and liquidity spirals cause financial instability. Increasing margins further restrict leverage and exacerbate the downturn. A demand for liquid assets and a role for money emerges. The market outcome is generically not even constrained ecient 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.
slides.pdf survey_macrofinance.pdf
Brunnermeier, Markus K, Patrick Bolton, and Laura Veldkamp. “

Leadership, Coordination and Corporate Culture

”. Review of Economic Studies 80.2 (2013): 512-537. Print.Abstract
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 organization's goals it also creates a time-consistency problem. Leader resoluteness is a valuable attribute in such a setting, since it slows down the leader's 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.
leadership.pdf
Overconfident leaders make more precise mission statement which enhances coordination among the followers by reducing the leaders' time-inconsistency problem.