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On Thursday, May 27, Markus Brunnermeier gave a lecture. Brunnermeier is the Director of the Bendheim Center for Finance.

Watch the full presentation below. You can also watch all Markus’ Academy webinars on the Markus’ Academy YouTube channel.

Executive Summary

  • Government bonds are valuable, even if the government remains in a deficit. The Fiscal Theory of Price Level links inflation to government debt and emphasizes the store of value role of money. Its key equation is the nominal value of government bonds divided by the price level equals the discounted present value of the primary surpluses. The new insight is that a bubble term needs to be added, so that (Bt/pt=Et[PVr(primary surplus)]+ Bubble.)  As with other things in Monetary Theory, Japanese experience provides a nice case study. In Japan fifty of the past sixty years, the government remained in a primary deficit, yet the bonds still were worth something. The bubble helps explain this because in this case, countries can have a primary deficit all the time – up to a certain level. This can occur without creating excessive inflation if the interest rate on the government bond is smaller than the growth rate of the economy (r<g). The interest is low if the government debt is a safe asset, i.e. it allows precautionary self-insurance via retrading and gains in value in times of recessions. The safe asset is like a good friend, it is around when you need it.
  • The interest rate on the safe asset is dictated by several factors: the risk free rate, the risk premium, and the convenience yield. The risk-free rate for a log-utility setting is the sum of the time preference rate (valuing future utility), the expected growth of consumption (higher rates for future wealth), and negative precautionary savings components consisting of the variance of aggregate and idiosyncratic consumption growth risk. A risk premium is added to the risk-free rate, accounting for inflation risk and the loss of safe asset status risk. Finally, the convenience yield is subtracted from the equation because of the ability to use government bonds as collateral. In short, mathematically:  ρ+E[gc] – [Vart[gc]+Vart[g̃c]} + risk premium – {λ(Collateral Constr)}.
    For the interest rate on money we have to subtract in addition Δi, since money allows one to overcome the “double-coincidence of wants”-friction.
  • Meaningful discount rate and “service flow”: Discounting at the market rate, can lead to an FTPL (Fiscal Theory of Price Level) formula where the first term tends to minus infinity, since permanent primary deficits grow at a rate higher than r, while the second term tends to be plus infinity. This equation is not very useful in obtaining the sum of both terms, which is a well-defined finite number. Using a discount rate of a representative agent instead, makes both terms finite and provides a nice economic interpretation not only for the discount rate, but also for the second term. The second term reflects the present value of future service flows. In particular, this term reflects the benefits from precautionary self-insurance through retrading.
  • The effects of shocks during recessionary periods are larger, increasing the value of precautionary self-insurance service flow. The safe assets can be traded between parties during any shocks, but during recessions, the risks become bigger. The overall risk is lower during a boom phase than during a recession. Hence, safe asset becomes more valuable in recessions, i.e. he has a negative CAPM-. Moreover, safe assets can insure both the bond holders and the taxpayers during recessions. This is because the value of the bonds will increase so much in recessions – insuring the bond holders – so that tax cuts are also possible – insuring the taxpayers during a recession.
  • US Monetary Policy implications, domestically and for EMDEs. Internationally local safe assets compete with global safe assets, e.g. the US Treasury. For emerging and developing economies, given that every country has its own safe assets, countries still compete for safe assets. Within a country, their safe asset “r” rate includes a risk premium. This risk premium makes it hard to exceed g to create the bubble. In addition, the local “r” has to be above the US rate to stay competitive. This means that if US rates increase, the safe asset bubble will burst, posing a challenge for EMDEs, and can often lead to large capital flows between countries. (Read Brunnermeier’s “International Monetary System: A Safe Asset Perspective” for more details).