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.

With energy five times as expensive … we would take a
substantial hit to incomes. Our living standard would decline by about 11
percent. But we would still be fantastically rich compared to the pre-industrial
world. … Our income would still be above the current living standards in
Canada, Sweden or England. Oh, the suffering humanity! At current rates of
economic growth we would gain back the income losses from having to convert to
solar power in less than six years….

That is Greg Clark, link here.

Cowen’s Third Law used to read "All propositions about real interest rates are wrong," so I hesitate to tread on this ground.  The question is, when inflation comes, why doesn’t the expectation of that inflation lead to proportional increases in nominal interest rates, thus keeping the real rate constant?  The studies I’ve seen all indicate a less than one-to-one Fisher effect.  I can think of a few hypotheses:

1. People systematically underestimate the forthcoming rate of price inflation.  (Still?)

2. People have generally adaptive expectations, but they will adjust quickly and rationally to big enough jolts.  And maybe inflation rises slowly, but deflations come all of a sudden.  So it seems there are more periods when people’s expectations are lagging an inflation than a deflation, and that will produce the data pattern stated above.

3. People have generally rational expectations in a game against nature, but they are playing a game against the Fed.  The Fed is smarter than the people.  And the Fed has studied Newcomb’s Paradox so it can, on average, figure out when a dose of inflation will surprise people (in a positive way, of course, socially speaking).  So every now and then we get these surprise bursts of inflation, but no comparable surprise bursts of deflation, which of course would not help output any.  In this set-up the Fisher effect won’t fully hold.

4. A Mundell-Tobin effect is operating, so real rates of return are falling because the inflation moves people out of currency and into capital.

5. The new money enters through the loanable funds market, thereby depressing real interest rates.

6. Sometimes things just don’t work out the way you think they ought to.

Once you consider the tax system, you realize how much the cards are stacked against our attempt to explain this.  Many people can deduct their nominal interest payments from their taxes, and that implies we should see a more than one-to-one Fisher effect from inflation.  But we don’t.

You’ll also note that under most of these explanations the specified dose of inflation does not have a significantly negative effect on private savings.  If the inflation is expected, the nominal interest rate adjusts.  If the inflation is not expected, it doesn’t scare off savings.

Do you have other ideas?  I believe the incomplete Fisher effect is a result which holds both across time and across countries, but maybe you know the latest paper which I don’t.

When I come to my office, I take my sweater off.  When I go home, I put my sweater back on.