Inefficient credit booms

This paper studies the welfare properties of competitive equilibria in an economy with financial frictions hit by aggregate shocks. In particular, it shows that competitive financial contracts can result in excessive borrowing ex ante and excessive volatility ex post.  Even though, from a first-best perspective the equilibrium always displays under-borrowing, from a second-best point of view excessive borrowing can arise.  The inefficiency is due to the combination of limited commitment in financial contracts and the fact that asset prices are determined in a spot market.  This generates a pecuniary externality that is not internalized in private contracts.  The model provides a framework to evaluate preventive policies which can be used during a credit boom to reduce the expected costs of a financial crisis.

Here is the paper, here is an ungated version.  If I understand this model correctly,  People invest too much ex ante.  If those (correlated) investments turn bad ex post, they have to sell lots of their assets to pay off their debts.  Those sales make asset prices more volatile, and what appear to be pecuniary externalities (falling and volatile prices) in fact bring real macroeconomic costs, as should be familiar to any observer of the current scene.  One implication is that government should prevent overborrowing, for instance by instituting capital requirements.  Bad outcomes are then less likely to require a fire sale of assets.

Expect to see more along these lines.  It may not sound like the Austrian theory of the trade cycle, but in both cases entrepreneurs overinvest in holding vulnerable positions.  The Austrians postulate a "thin skull" response to low interest rates (too much investment in long-term production processes); this model starts with a distinction between private and social returns.  Here is another interesting paper by the same researcher.

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