The Macroeconomics of Debt and Financial Markets

The goal of my dissertation is to further our understanding of the linkages between financial market fluctuations and real macroeconomic outcomes. The first chapter explores the relationships between international portfolios, external default, and world financial fluctuations. The second chapter is about fat tails in the U.S. consumption distribution and their implications for estimating heterogeneous agent asset pricing models. In the third chapter, we prove that in competitive market economies with no insurance for idiosyncratic risks; agents will always overinvest in high yielding but illiquid long term assets and underinvest in short term liquid assets.;The title of Chapter 1 is "Portfolio Choice and Partial Default in Emerging Markets: a Quantitative Analysis," and the motivating question of this chapter is, what are the determinants and economic consequences of cross-border asset positions? I develop a new quantitative portfolio choice model and apply it to emerging market international finance. The model allows for partial default and accommodates trade in a rich set of assets. The latter means I am able to draw distinctions both between debt and equity finance and between gross and net debt. The main contribution is in developing portfolio choice techniques to analyze capital flows and default in an international finance context. I calibrate the pricing kernel of the model to match properties of U.S. stock returns and yield curves. I then analyze optimal emerging market portfolio and default behavior in response to realistic international financial fluctuations. My calibrated model jointly captures four empirical regularities that have been difficult to produce in the quantitative international finance literature: (1) Gross capital inflow and outflow are pro-cyclical. My model generates this as well as pro-cyclicality in equity liabilities and short-term debt. This is important because recent empirical work emphasizes that the level and composition of gross capital flows are at least as important as current accounts in understanding risk and predicting crises. (2) Most external defaults are partial. (3) Levels of gross external debt in excess of 50% of GNI are common. (4) Usually, borrowers default in bad economic times.;Chapter 2, titled "The Double Power Law in Consumption and Implications for Estimating Asset Pricing Models," is joint with Alexis Akira Toda. Contrary to conventional wisdom, we find that the cross-sectional distributions of U.S. consumption and consumption growth are better described by the double Pareto-lognormal distribution, which obeys the power law in both tails, than by the lognormal distribution. We estimate the power law exponent to be about 4 in both cases, implying the population moments of order > 4 or < --4 are not likely to exist. In light of this finding, we reevaluate the models of a number of consumption-based asset pricing papers that use the Consumer Expenditure Survey to build stochastic discount factors (SDFs). We draw three main conclusions. First, many estimators in the literature may be inconsistent. Second, the power law in consumption appears to have the ability to generate spurious acceptance of asset pricing models in explaining the equity premium. Third, estimation using simulated data from a tractable general equilibrium model supports our theory that the power law interferes with testing and estimating heterogeneous agent asset pricing models.;Chapter 3, titled "Inefficient Liquidity Provision," is joint with John Geanakoplos. Since the seminal analysis of Diamond and Dybvig (1983), a large literature has explored inefficiencies that may arise when intermediaries provide liquidity insurance to investors. These papers either (1) emphasize the role of intermediaries, (2) assume the original, and quite special, Diamond-Dybvig preference form, or (3) abstract from aggregate interest rate risk. Departing from (1)-(3), we analyze the portfolio decisions and welfare of investors in a three-period, competitive equilibrium economy. The agents are ex ante identical and have decreasing absolute risk aversion. However, after date 0, agents are uncertain about how much they will discount date 2 utility when they get to date 1. That is, some agents will become more impatient than others. Furthermore, at date 0, agents place more weight on their future impatient selves, so they allocate more to a low-yield, short-term investment. The fraction of impatient agents is random, so investors face aggregate interest rate risk in addition to idiosyncratic impatience risk. We prove that welfare can always be improved by policies limiting investment in a long-term asset. The implication is that, in a model consisting of just individual investors (no intermediaries) and competitive, anonymous asset markets, equilibrium is constrained inefficient.