Papers of Aaron Tornell.

·         Financial Crises, Financial Liberalization and Boom-Bust Cycles

Systemic Crises and Growth (2008, Quarterly Journal of Economics), with Romain Ranciere and Frank Westermann

Abstract:    Countries that have experienced occasional financial crises have, on average, grown faster than countries with stable financial conditions. Because financial crises are realizations of down-side risk, we measure their incidence by the skewness of credit growth. Unlike variance, negative skewness isolates the impact of the large, infrequent and abrupt credit busts associated with crises. We find a robust negative link between skewness and GDP growth in a large sample of countries over 1960-2000. This suggests a positive effect of systemic risk on growth. To explain this finding, we present a model in which contract enforceability problems generate borrowing constraints and impede growth. In financially liberalized economies with moderate contract enforceability, systemic risk taking is encouraged and increases investment. This leads to higher mean growth, but also to greater incidence of crises. In the data, the link between skewness and growth is indeed strongest in such economies. Unpublished Appendix to Systemic Crises and Growth (May 2007)

Financial Liberalization (2007, New Palgrave Dictionary)

Decomposing the Effects of Financial Liberalization: Crises vs. Growth (December 2006, Journal of Banking and Finance), with Romaine Ranciere and Frank Westermann

Abstract:    We present a new empirical decomposition of the effects of financial liberalization on economic growth and on the incidence of crises. Our empirical estimates show that the direct effect of financial liberalization on growth by far outweighs the indirect effect via a higher propensity to crisis. We also discuss several models of financial liberalization and growth whose predictions are consistent with our empirical findings.

Concentrated Ownership and Bailout Guarantees (November 2005), with Martin Schneider

Abstract:    This paper studies the effect of bailout guarantees in an economy where ownership of firms is concentrated. In contrast to standard models of deposit insurance, bailout guarantees need not generate excessive risk taking, but may instead alleviate underinvestment. While the economy can experience wasteful lending booms, such booms often end in a self-correcting soft landing, as in the data. However, an economy that operates efficiently can also relapse into episodes of inefficient over- or underinvestment. Financial development has unintended consequences as it provides markets with tools to better exploit the bailout guarantee.

Balance Sheet Effects, Bailout Guarantees and Financial Crises (2004, Review of Economic Studies), with Martin Schneider

Abstract:    This paper provides a model of boom-bust episodes in middle income countries. It features balance-of-payments crises that are preceded by lending booms and real appreciation, and followed by recessions and sharp contractions of credit. As in the data, the nontradables sector accounts for most of the volatility in output and credit. The model is based on sectoral asymmetries in corporate finance. Currency mismatch and borrowing constraints arise endogenously. Their interaction gives rise to self-fulfilling crises.

Liberalization, Growth and Financial Crises (December 2003, Brookings Papers on Economic Activity), with Frank Westermann and Lorenza Martinez

Abstract:    At first glance, the experience of Mexico, a prominent liberalizer, challenges the argument that liberalization promotes growth. However, when we compare Mexico against an international norm, we find that the growth in Mexico’s exports during the 1990s was outstanding. We also find that, although its pattern of boom and crisis is similar to that of the average liberalizing country, Mexico’s credit crunch in the wake of its crisis has been atypically severe and long-lasting. This credit crunch, together with a lack of structural reform since 1995, has resulted in stagnation of the nontradables sector, generating bottlenecks that have contributed to Mexico’s less-than-stellar growth performance and to the more recent fall in exports.

Crises and Growth: A Re-evaluation (September 2003), with Romain Ranciere and Frank Westermann

Abstract:    We address the question of whether growth and welfare can be higher in crisis-prone economies. First, we show that there is a robust empirical link between per-capita GDP growth and negative skewness of credit growth across countries with active financial markets. That is, countries that have experienced occasional crises have grown on average faster than countries with smooth credit conditions. We then present a two-sector endogenous growth model in which financial crises can occur, and analyze the relationship between financial fragility and growth. The underlying credit market imperfections generate borrowing constraints, bottlenecks and low growth. We show that under certain conditions endogenous real exchange rate risk arises and firms find it optimal to take on credit risk in the form of currency mismatch. A long such a risky path average growth is higher, but self-fulfilling crises occur occasionally. Furthermore, we establish conditions under which the adoption of credit risk is welfare improving and brings the allocation nearer to the Pareto optimal level. The design of the model is motivated by several features of recent crises: credit risk in the form of foreign currency denominated debt; costly crises that generate firesales and widespread bankruptcies; and asymmetric sectorial responses, where the nontradables sector falls more than the tradables sector in the wake of crises.

Credit Market Imperfections in Middle Income Countries (January 2003), with Frank Westermann

Abstract:    In recent decades many middle income countries (MICs) have liberalized their financial markets. Financial liberalization has typically been followed by lending booms during which credit grows unusually fast. Some of these booms have been punctuated by twin currency and banking crises that are followed by a protracted credit crunch. In this paper we document three credit market imperfections prevalent in MICs that can explain these boom-bust cycles as well as other macroeconomic patterns observed at higher frequencies across MICs. These imperfections are the existence of borrowing constraints (the effects of which differ across sectors), currency mismatch and systemic bailout guarantees.

The Credit Channel in Middle Income Countries (October 2002), with Frank Westermann

Abstract:    Credit market conditions play a key role in propagating shocks in middle income countries (MICs). In particular, shocks to the spread between domestic and international interest rates have a strong effect on GDP, and an even stronger effect on domestic credit. This strong credit channel is associated with a sharp sectorial asymmetry: the output of the bank-dependent nontradables (N) sector reacts more strongly than tradables (T) output. This asymmetry, in turn, is associated with a strong reaction of the real exchange rate —the relative price between N and T goods. We present a model that reconciles these facts and leads to a well specified estimation framework. From the equilibrium we derive structural VARs that allow us to identify shocks to credit market conditions and trace their effects on the economy. We estimate these structural VARs for a group of MICs and find evidence of a strong credit channel. We argue that at the heart of the MIC credit channel are a deep asymmetry in financing opportunities across N and T sectors, and a severe currency mismatch. This makes movements in the real exchange rate the driving element in the amplification of shocks. Finally, we show that the model’s key assumptions are consistent with evidence gleaned from both firm level and aggregate data.

Soft Landings (February 2000), with Martin Schneider

Abstract:    A country experiencing a lending boom goes through a period of unusually fast growth in credit. This paper proposes a theory of lending booms that incorporates two distortions which are prevalent in emerging markets: the imperfect enforceability of contracts and government bailout guarantees. The first of distortion implies that there may be an underinvestment problem and that shocks are propagated through their effect on borrower wealth. The second distortion amplifies shocks since it encourages excessive risk taking and overinvestment. Although they appear to affect borrowing in opposite ways, the tow distortions do not neutralize each other. They combine to rationalize the gradual buildup of lending booms, the excess volatility of credit and asset prices and the slow recovery if a lending boom ends in a financial crisis. The interaction also introduces a nonlinearity in the response to shocks. This explains why most lending booms do not require a large negative shock to end, but rather come to a ’soft landing’. In addition to accounting for the main characteristics of a typical lending boom episode the model also surprising policy implications.

The Role of Bank Restructuring in Recovering From Crises: Mexico 1995-1998 (March 1999), with Anne Krueger

Abstract:    The remarkable turnaround of the Mexican economy and the evolution of the banking problem is of interest in its own right. In addition, it is of interest to policy makers in other countries where debt-servicing difficulties and foreign exchange crisis have forced adjustment measures. In this paper, therefore, we examine the causes of the crisis, the crisis itself (insofar as it is relevant to understanding the response), and the evolution of the Mexican economy since the crisis.

Book:  Boom-Bust Cycles and Financial Liberalization (2005, MIT Press), with Frank Westermann


·         Exchange Rates, Asset Pricing and Robust Control

Exchange Rates Under Robustness: The Forward Premium Puzzle and Momentum (November 2008), with Ming Li

Abstract:    We show that robustness against model misspecification can account for the forward premium puzzle through a combination of an exchange rate model and a robustness model under structured uncertainty. In equilibrium, optimizing agents, who hold no misperception about the model, distort their forecasts to attain robustness against potential misspecification. This forecast distortion generates a delayed overreaction of exchange rates to interest rate differential shocks that leads to a negative unconditional correlation between exchange rate changes and interest rate differentials, i.e., a negative Fama coefficient. Using change-of-measure techniques, we derive the familiar uncovered interest rate parity condition—under distorted expectations—and the Fama coefficient in closed-form. We calibrate our model with empirical estimates of key parameters and are able to generate a negative Fama coefficient under sufficient uncertainty-aversion. Extended Appendix to Exchange Rates Under Robustness: The Forward Premium Puzzle

Exchange Rate Puzzles and Distorted Beliefs (June 2003), with Pierre-Olivier Gourinchas

Abstract:    We propose a new explanation for the foreign exchange forward-premium and delayed-overshooting puzzles. We show that both puzzles arise from a systematic distortion in investor’s beliefs about the interest rate process. Accordingly, the forward premium is always a biased predictor of future depreciation; the bias can be so severe as to lead to negative coefficients in the ‘Fama’ regression. Delayed overshooting may or may not occur depending upon the persistence of interest rate innovations and the degree of misperception. We document empirically the extent of this distortion using survey data for G-7 countries against the U.S. and find that it is strong enough to account for these irregularities.

Exchange Rate Anomalies Under Model Misspecification: A Mixed Optimal/Robust Approach (January 2003)

Abstract:    Many asset pricing anomalies imply the existence of time-varying predictable excess returns, as well as short-run underreaction and long-run overreaction to news. The presence of short-sales constraints or of misperception has been often invoked to explain such patterns. In this paper I present a ‘mixed optimal/robust’ model with rational agents that hold no misperception and face no borrowing constraints. In equilibrium, agents do not borrow as much as they could, and filter news in ways that are consistent with the anomalies mentioned above. We use the model to rationalize the forward premium puzzle.

Robust-H_infinity Forecasting and Asset Pricing Anomalies (December 2001)

Abstract:    We present a Robust-H_infinity model that helps rationalize well known asset pricing anomalies, such as the predictability of excess returns, excess volatility, and the equity-premium puzzle. As with rational expectations (RE), agents’ forecasts are based on a rigorous optimization algorithm that does not presume misperceptions — it simply departs from some of the implicit assumptions that underlie RE. Agents fear the existence of misspecification and design strategies that will be robust against a very large class of misspecifications. The new element is that uncertainty cannot be modeled via probability distributions. We consider an asset pricing model where uncertainty is represented by unknown-but bounded disturbance sequences, as in the H_infinity -control literature. Agents must filter the ‘persistent’ component of a sequence of dividend observations in order to make consumption and portfolio decisions. We find that H_infinity forecasts are more sensitive to news than RE forecasts and equilibrium prices exhibit the anomalies previously mentioned.