1. Capital Flows, Interest Rates and Precautionary Behaviour: a model of “global imbalances” Marcus Miller and Lei Zhang Discussion Romain Ranciere (IMF) usual disclaimer applies

2. A very interesting paper that proposes an integrated framework to jointly analyze two important questions: – Global Imbalances: large US Current Account Deficit and low interest rate – Precautionary Motive for Reserves Accumulation

3. a previous look on the link: –view of reserves accumulation as “mercantilist” policies (Dooley and al.) but –Aizenman-Lee (2006): more empirical support for precautionary motive view than for mercantilist view: a more liberal capital account increases international reserves.

4. Models of precautionary reserves –Caballero-Panageas (2005); Jeanne-Ranciere (2006) –small open “emerging” economy –no market for reserves assets; exogenous interest rate –Insurance against “sudden stops” –insurance domestic absorption/consumption against capital outflows [+ via balancesheet effect associated output losses)] –Crisis prevention / Crisis smoothing

5. Model of Global Imbalances and low-interest rates –Deterministic Models e.g. Caballero and al. (growth differential; capital market impefections) –No risk; No demand for insurance –Demand for insurance + Capital Market Imperfection  Self-insurance

6. Miller-Zhang Model(s) 2 “countries” (safe: US; risky: ROW); 2 period (risk in period 2) risk: mean preserving output risk. GDP insurance (vs. SS insurance) capital market (complete: insurance; incomplete: self-insurance) risk-aversion (standard log utility; loss-avoidance) intertemporal smoothing; crisis smoothing general result: the risky country saves i.e. is net buyer of insurance securities (-> current account surplus in period 1). insurance premium ~ lower interest rate. remark: the 2-period case allows to mask an assumption on hard credit constraint in bad times. (sudden stop literature: time-varying credit constraint)

7. Insurance –complete market: contigent claims. sell goods in good state for goods in bad states. –remark: if the insurer was risk-neutral (and competitive)  no imbalance –the insurer is risk-averse-> modest imbalance.[<0.2% of GDP] Self-insurance –incomplete market: accumulates risk-free asset government bonds –higher demand for US government bonds (  lower interest rate) –but (still) modest imbalance [<0.5% of GDP] –why so little self-insurance? –cost/benefit of insurance: intertemporal distorsion vs. between-state distorsion. [increasing per unit cost of self-insurance]

8. Risk-Aversion Issues –log utility; constant relative risk-aversion~1. –Jeanne-Ranciere (2006) dramatic shift in demand for insurance between risk-aversion 1 and 4. [but more “crisis” insurance also means less “intertemporal smoothing”] –Natural extension: Epstein-Zin preferences  separate preferences for intertemporal substitution and risk-aversion.

9. Loss Avoidance –downside risk is more costly than upside gains. –capture more broadly the “costs of crises”: political costs; distributional issues  worth developing. –alternative view: learning and overshooting  misperception on the economic costs of crisis –RESULTS: combination of LA+severe output risk  CAD 5% and possibility of negative real interest rate –Notice: here nominal = real  one good. otherwise negative return  US depreciation. –US bonds is not a good insurance  needs to buy a lot to get self- insurance “war chess”  crises are specially costly  ready to pay negative interest rate (cost of storage)

10. comparison with Jeanne-Ranciere (2006): insurance against sudden stop –Key difference: maturity transformation. the government accumulates reserves because it is less credit constrained than private sector [it can borrow long term while private sector borrows short-term] –cost of a crisis is capital outflows (11%) and output cost (6.5%)  17.5%  reserves of 9.7% –crises are rare and severe events (pi=10%); risk-aversion is higher (2). At sigma=1 : zero reserves! Cost of Reserves: term premium. 1.5% Miller and Zhang: “excess” saving and insurance premium

11. remarks/questions somehow unresolved tension: sudden stops and global imbalances. sudden stop typically occurs in the risky country with net capital inflows. who fears a sudden stop now (US or emerging?) good simple model; possible extension towards calibration –break-even more the symmetry (growth differential; different shocks, different size  paper by Imbs and Mauro (Pooling)) –real exchange rate depreciation –estimation of the parameters (->time-varying parameter) – OLG /simulation. global temporary phenomenon (temporary buildup...): yes and no: probability of sudden stop increases with financial openness US big insurer? can the insurer fail? risk-less or just less-risky US securities?