# 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.

Brunnermeier, Markus K., and Lunyang Huang. “A Global Safe Asset From and For Emerging Economies”. Working Paper: n. pag. Print.
Brunnermeier, Markus K., and Dirk Niepelt. “On the Equivalence between Private and Public Money”. Working Paper: n. pag. Print.
Abadi, Joseph, and Markus K. Brunnermeier. “Blockchain Economics”. Working Paper: n. pag. Print.Abstract

When is record-keeping better arranged through distributed ledger technology (DLT) than through a traditional centralized intermediary? The ideal qualities of any record-keeping system are (i) correctness, (ii) decentralization, and (iii) cost efficiency. We point out a \textit{Blockchain Trilemma}: no ledger can satisfy all three properties simultaneously. A centralized ledger writer extracts rents due to its monopoly on the ledger. Its franchise value dynamically incentivizes honest reporting. Decentralized ledgers provide static incentives for honesty through computationally expensive Proof-of-Work algorithms but eliminate rents through "fork competition." Portability of information between "forks" and competition among miners fosters competition among decentralized ledgers that is fiercer than traditional competition. However, fork competition can engender instability and miscoordination. While blockchains can keep track of ownership transfers, enforcement of possession rights is still needed in many blockchain applications.

Brunnermeier, Markus K., Pierre-Olivier Gourinchas, and Oleg Itskhoki. “Consumption-led Growth”. (Working Paper). Web. Publisher's Version
Brunnermeier, Markus K., et al.Feedbacks: Financial Markets and Economic Activity”. Working Paper: n. pag. Print.Abstract

We examine the relation among measures of credit expansion, measures of financial market stress, and standard macroeconomic aggregates. We use a form of structural VAR with monthly data on 10 variables. The model explains observed variation as driven by 10 mutually independent structural disturbances. We identify the shocks from variation across time in their relative variability. One of them emerges as representing monetary policy. We find two distinct financial stress shocks, suggesting that attempts to create a one-dimensional index of financial stress may be misguided. While our results are consistent with the finding by others of a negative reduced form relation between credit expansion and future output growth at certain frequencies, we find the output decline to be explained by the monetary policy response to the inflation that accompanies the credit expansion. In pseudo-out-of-sample forecasting tests, neither bond spreads, interbank spreads, nor credit aggregates had much predictive value far in advance of the 2008-9 downturn, though spreads (but not credit aggregates) were helpful in recognizing the downturn once it had begun.

Brunnermeier, Markus K., Michael Sockin, and Wei Xiong. “China's Model of Managing its Financial System”. China's Model of Managing its Financial System Working Paper: n. pag. Print.Abstract

China's economic model involves active government intervention in financial markets. It relaxes/tightens market regulations and even directs asset trading with the objective to maintain market stability. We develop a theoretical framework that anchors government intervention on a mission to prevent market breakdown and the explosion of volatility caused by the reluctance of short-term investors to trade against noise traders when the risk of trading against them is sufficiently large. In the presence of realistic information frictions about unobservable asset fundamentals, our framework shows that the government can alter market dynamics by making noise in its intervention program an additional factor driving asset prices, and can divert investor attention toward acquiring information about this noise rather than fundamentals. Through this latter channel, the widely-adopted objective of government intervention to reduce asset price volatility may exacerbate, rather than improve, the information efficiency of asset prices.

Brunnermeier, Markus K., and Yann Koby. “The Reversal Interest Rate”. (Working Paper). Print.Abstract

The "reversal interest rate'' is the rate at which accommodative monetary policy reverses'' its intended effect and becomes contractionary for lending. It occurs when recapitalization gains from the duration mismatch are offset by decreases in net interest margins, lowering banks' net worth and tightening its capital constraint. The determinants of the reversal interest rates are (i) banks asset holdings with fixed (non-floating) interest payments, (ii) the degree of interest rate pass-through to deposit rate, (iii) the capital constraints that they face. Low interest rates beyond the time when fixed interest rate mature do not lead to recapitalization gains while still lowering banks' margins, suggesting a shorter forward guidance policy: the reversal interest rates "creep up". Moreover, interest rate cuts can have heterogeneous effects across regions where monetary policy operates, being possibly expansionary in one region and contractionary in another. Furthermore, quantitative easing increases the reversal interest rate. QE should only be employed after interest rate cut is exhausted.

In Preparation
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.

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.

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.

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.

2017
Brunnermeier, Markus K., Michael Sockin, and Wei Xiong. “China's Gradual Economics Approach and Financial Markets”. American Economic Review Papers and Proceedings 107.5 (2017). Print.Abstract

China’s gradualistic approach allowed the government to learn how the economy reacts to small policy changes, and to adjust its reforms before implementing them in full. With fully developed financial markets, however, private actors’ may front-run future policy changes making it impossible for the implement policies gradually. With financial markets the government faces a time-inconsistency problem. The government would like to commit to a gradualistic approach, but after it observes the economy’s quick reaction, it has no incentive to implement its policies in small steps.

Brunnermeier, Markus K., et al.ESBies: Safety in the Tranches”. Economic Policy (2017). Print.Abstract

The euro crisis was fueled by the diabolic loop between sovereign risk and bank risk, coupled with cross-border flight-to-safety capital flows. European Safe Bonds (ESBies), a union-wide safe asset without joint liability, would help to resolve these problems. We make three contributions. First, numerical simulations show that ESBies would be at least as safe as German bunds and approximately double the supply of euro safe assets when protected by a 30%-thick junior tranche. Second, a model shows how, when and why the two features of ESBies---diversification and seniority---can weaken the diabolic loop and its diffusion across countries. Third, we propose a step-by-step guide on how to create ESBies, starting with limited issuance by public or private-sector entities.

Brunnermeier, Markus K., and Yuliy Sannikov. “Macro, Money and Finance: A Continuous-Time Approach”. Handbook of Macroeconomics. North-Holland, 2017. 1497-1546. 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.

Brunnermeier, Markus K., Filippos Papakonstantinou, and Jonathan A. Parker. “Optimal Time-Inconsistent Beliefs: Misplanning, Procrastination, and Commitment”. Management Science 63.5 (2017): , 63, 5, 1318-1314. Web. Publisher's VersionAbstract

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.

2016
Brunnermeier, Markus K, and Yuliy Sannikov. “On the Optimal Inflation Rate”. American Economic Review Papers and Proceedings 106.5 (2016): , 106, 5, 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.

Brunnermeier, Markus K, et al.The Sovereign-Banking Diabolic Loop and E S Bies”. American Economic Review Papers and Proceedings 106.5 (2016): , 106, 5, 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.

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)

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.

Adrian, Tobias, and Markus K Brunnermeier. “Co Va R”. American Economic Review 106.7 (2016): , 106, 7, 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.

Predicting and measuring a financial institution's contribution to systemic risk that internalizes externalities and avoids procyclicality.

2015
Brunnermeier, Markus K, and Yuliy Sannikov. “International Credit Flows and Pecuniary Externalities”. American Economic Journal: Macroeconomics 71 (2015): , 7, 1, 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.

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.

Brunnermeier, Markus K, and Martin Oehmke. “Predatory Short Selling”. Review of Finance 18.6 (2014): , 18, 6, 2153-2195. Web. Publisher's VersionAbstract

Financial institutions may be vulnerable to predatory short selling. When
the 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.

Winner of Pagano-Zechner Prize