The Macroeconomics of Asset Shortages Ricardo J. Caballero MIT and NBER http://web.mit.edu/caball/www Fall 2007

Overview A conjecture… Excess demand for (financial assets) store of value and collateral by households, corporations, governments, insurance companies, financial intermediaries No direct evidence…(both supply and demand are very hard to measure) But the implications of this single ingredient are consistent with many of the main macroeconomic events of the last decade and more (Occam’s razor )… Dark matter…

Overview Equilibrium response of asset prices and valuations have macroeconomic implications “Global imbalances” Recurrent speculative “bubbles’’ (emerging markets, dot-coms, real estate, gold, commodities, emerging markets…) Flight to quality episodes Low long real interest rates Low inflation and deflations Rebalancing is a response to changes in the location of asset production

Emerging Markets Capital’s ability to produce output is only imperfectly linked to its ability to generate assets Weaknesses: Institutional, macroeconomic, political, liquidity Result: Asset shortage is a chronic feature. Cycles of capital outflows (store value abroad) and domestic bubbles (store value in fragile coordination dependent assets)

Synchronization of Boom and Bust in Capital Flows Collapse in Capital Flows to SE Asia in the Late 90s Capital Flows to SEA-5* (in millions of US dollars, last four quarters) Synchronization of Boom and Bust in Capital Flows (in % of GDP, last four quarters) 80000 Asian Crisis 60000 Boom Bust 40000 Average 1984-88 peak 1996 peak 1996 vs vs vs peak 1996 trough 1998 2002 20000 Thailand 9,7 -22,6 -11,2 Indonesia 2,6 -21,9 -7,0 Korea 6,4 -20000 -14,5 -3,2 Philippines 8,0 -10,3 -14,8 -40000 Malaysia 6,1 -5,7 -10,9 -60000 SEA-5 6,1 -15,0 -9,4 -80000 Jan-90 Nov-90 Sep-91 Jul-92 Mar-89 May-93 Mar-94 Jan-95 Nov-95 Jul-02 Sep-96 Jul-97 May-98 Mar-99 Jan-00 Nov-00 Sep-01 *SEA-5 includes Indonesia,Korea, Malaysia, Philippines and Thailand Source: Calvo et al (2006)

The World Economy Globalization transfers local asset shortages to the world at large Asset crashes around the world (Japan, EMs) reduced the supply of assets (today…) Large asset shortages in China and commodity-economies Anglo-Saxon economies, and the US in particular, are the main asset producers Large capital gains and flows to producers of scarce assets

The so-called “global imbalances” is a symptom of asset-scarcity Capital gains and losses are very heterogeneous across the world

Low interest rates It is one of the market mechanisms to create assets (increase value) out of the few ones it has

Low inflation is another It is the market mechanism to increase the value of scarce nominal assets

The World Economy: Bubbles … and yet another market mechanism (recall EMEs) is high valuations or speculative bubbles

The World Economy: Bubbles Bubbles in “the small”: We tend to focus on (be distracted by?) risk-shifting, regulatory problems, etc. Most recent example: sub-prime My view: these are mainly stories of “location” Instead, the real story is what creates the environments that are conducive to speculative behavior… Shortage of assets… (btw, central bank supplied liquidity is endogenous…)

The World Economy: Bubbles The environment is much harder to deal with than a specific problem in a specific market… Trying to chase and prick bubbles may lead to lots of instability and very limited success… (conservation law) Bubbles are providing a useful service Problems: They introduce volatility / location (huge problem for EMEs) May distort allocation of factors of production (e.g. real estate)

The World Economy: Bubbles Solution: ??? Short run: (science fiction…) Try to spread them Concentrate them on non-resource consuming / input assets In any event, interest rate policy has little to do with this, aside from the “divine coincidence” (excessive aggregate bubbles lead to inflation) Long run: financial development in the South…

Flight to Quality Shortage of assets leads to high valuations and the emergence of speculative bubbles with uncertain location In turn, these factors lead to financial innovation and effectively uncollateralized leverage, which leave the economy exposed to flight to quality episodes (Knightian uncertainty)

$250 Billion 1% change in the stock market > $250 billion Why has this created a credit crisis? The Dow fell from near 14,000 pre-crisis to a low of 13,000 on 8/16 7% fall = $2.1 trillion of loss in wealth 8X the subprime loss !

Uncertainty Newness Short historical record Past prices for statistical analysis? How do securities react in a stress event? Who is exposed? “ When confronted with uncertainty, human beings invariably attempt to disengage from medium to long-term commitments in favor of safety and liquidity” -Alan Greenspan after the 1998 Crisis

Flight to Quality Regulator’s incentive is to impose larger collateral holdings Costly in an environment with asset scarcity If F-to-Q doesn’t go away, or too much regulation, the cost will be large since frozen assets exacerbate the asset shortage. Non-recessionary interest rate is much lower… Hope: where will these savings go in the medium run? Not many options at the aggregate level… this is one of the main reasons we are in this environment…

World Rebalancing The dollar has depreciated about 20% relative to the Euro over the last year, and even more relative to some EMEs… why? Loss of growth advantage vs Euro area and Japan Sub-prime crisis Emerging market bubbles are being reignited Prices (exchange rate) change faster than quantities

Summary A simple ingredient, a shortage of store-of-value assets, can explain the main global macroeconomic phenomena of recent years Global “imbalances”, low real interest rates and inflation, emergence of speculative bubbles, flight to quality episodes… Volatility, associated to financial markets phenomena, is an intrinsic and unavoidable feature of an environment with such shortage

The Macroeconomics of Asset Shortages Ricardo J. Caballero MIT and NBER http://web.mit.edu/caball/www Fall 2007