1 Discussion of Long-run effects of idiosyncratic uncertainty in a model with credit market frictions by Morozumi and Ormaechea Stephen Millard Bank of England 12 November 2010

2 Motivation Many commentators have looked at the role of uncertainty in business cycles But less investigation of ‘long-run’ impact on output and credit supply of uncertainty But important what you mean by ‘long run’ –More on this later Additionally, recent crisis saw a rise in uncertainty, fall in credit and a fall in output

3 Key findings Increase in uncertainty leads to a long-run fall in output and a long-run fall in the credit-to-output ratio Can explain long-run correlation between the two –But what do we mean by long-run correlation? More later

4 Modelling Approach Entrepreneurs need to borrow to finance working capital –cf My paper with Michael McMahon and others to be presented later Uncertainty about output (sales?) at time loan is made leads to possibility of default This implies a risk premium on these otherwise interest-free loans

5 Modelling Approach I’m not sure about interest-free loans Loans are ‘within period’ within the model but surely this still implies some time? Banks typically have to fund their loans from somewhere so I’d expect to see some sort of funding cost –Both aspects present in Fernandez-Corugedo et al. –But may not matter for the results of this paper?

6 Modelling Approach Distortion arises from the ‘costly state verification’ problem –Key parameter is , the monitoring cost –As ever, this might be better thought of as ‘losses arising in bankruptcy’ costs –Technical comment (1): Can banks seize a defaulting firms capital? They should do. Is this distortion really relevant for such short-term loans?

7 Modelling Approach Intuitively, it is the uncertainty associated with investment projects that you might think gives rise to a costly state verification problem Yet, all investment in this model is done out of retained earnings Is there really much (any) uncertainty about production within a period? –There may be about sales …

8 Modelling Approach Technical comment (2): –I think the entrepreneurs budget constaint might be wrong (though it could just be me!) –Should it not be: –This error carries through until you make the assumption that  equals 1 –But I’m not sure it makes and qualitative difference to your results anyway

9 Results and comments Compare steady states of the model with different degrees of uncertainty An increase in uncertainty – measured as a mean preserving spread (MPS) in idiosyncratic productivity shocks – leads to a fall in steady-state output and the credit- output ratio –Provided distribution of shocks is symmetric and bell-shaped and the default rate is small enough.

10 Results and comments As long as a MPS leads to an increase in the deadweight loss associated with the CSV problem, then output and the credit-output ratio will fall –I must admit to being confused over the difference between the deadweight loss and the ‘entrepreneurs share’ distortion; I’d appreciate some intuition as to whether or not this is a separate distortion (I think not) and why it adds to the existing deadweight loss

11 Results and comments For their particular calibration, the result follows Does the result depend on using a beta distribution? –Would increasing the standard deviation of other distributions – normal, t – achieve the same effect? –Is a beta distribution reasonable for the sort of uncertainty they’re thinking about? The authors flag further work that’s relevant here.

12 Results and comments Section 3.5 gives the sign of some derivatives given their calculations –What does it add over Section 4? The effect on output looks very small –Or is it that the movements in uncertainty they look at are small? I’m afraid I don’t know how to think about this. –Back to my original motivation: the recent credit crisis seems to have lowered output by roughly 8%.

13 General comment What do we mean by ‘long-run’ effects? Authors compare their results to the literature that says that output and the credit-output ratio are positively correlated in the long run To me, that means that as output has grown, so has the credit-output rate –Surely idiosyncratic uncertainty cannot have trended downwards?

14 General comment Potential output Actual output Credit-output ratio Increase in uncertainty Authors’ model seeks to explain the break in the trend rather than the trend itself The literature on financial deepening is all about the trend