Working Paper: NBER ID: w25373
Authors: Markus K. Brunnermeier; Lunyang Huang
Abstract: This paper examines how a newly designed global safe asset can mitigate international capital flows induced by flight-to-safety. In the model domestic investors have to co-invest in a safe asset along with their physical capital. At times of crisis, investors replace the initially safe domestic government bonds with safe US Treasuries and re-sell part of their capital. The reduction in physical capital lowers GDP and tax revenue, leading to increased default risk justifying the loss of the government bond's safe-asset status. We compare two ways to mitigate this self-fulfilling scenario. In the “buffer approach” international reserve holding reduces the severity of a crisis. In the “rechannelling approach” flight-to-safety capital flows are rechannelled from international cross-border flows to flows across two EME asset classes. The two asset classes are the senior and junior bond of tranched portfolio of EME sovereign bonds.
Keywords: No keywords provided
JEL Codes: E42; E43; F32; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| replacement of domestic government bonds with US treasuries during a crisis (H63) | reduction in physical capital (E22) |
| reduction in physical capital (E22) | lower GDP (E20) |
| lower GDP (E20) | lower tax revenue (H29) |
| lower tax revenue (H29) | increasing default risk (G33) |
| buffer approach (holding international reserves) (F32) | mitigate the severity of a crisis (H12) |
| rechanneling approach (creating SBBS) (O35) | prevent capital flight (F32) |
| rechanneling approach (creating SBBS) (O35) | stabilize capital flows (F32) |
| rechanneling approach (creating SBBS) (O35) | protect domestic economies from adverse effects of sudden capital outflows (F32) |