Macroeconomics Collapse and Prevention
Macroeconomics Collapse and Prevention
Abstract
We present a feasible two-period framework for financial crises that accurately reproduces empirical patterns where credit-driven increases in asset prices are frequently succeeded by subsequent busts and prolonged recessions linked to reductions in productivity. We contend that the phenomenon of risk-shifting booms in asset values tends to collapse, leading to a subsequent increase in debt overhang. This, in turn, hurts productivity and production as it deters borrowers from investing their efforts. The aforementioned inefficiency is further exacerbated by the externality of a reduction in aggregate demand. Greater increases in asset prices result in more severe economic downturns. Ex-post-government intervention aimed at facilitating debt restructuring has the potential to enhance welfare by mitigating external demand and reducing the impact of time inconsistency.
Introduction
Recent empirical studies have revealed certain empirical patterns regarding the occurrence of booms and collapses in asset prices. Specifically, when there is a boom in asset prices that is accompanied by a credit boom or is driven by an expansion in credit supply, an asset boom tends to result in a bust. This is then followed by a prolonged and severe recession, characterized by a decrease in observed total productivity of factors (TFP). For instance, Jorda, Schularick, and Taylor (2015) can be cited as an example. The objective of the research is to develop a concise and manageable model that may be used to reproduce these observed patterns. One notable characteristic of this model is its ability to establish a connection between the decrease in productivity following the asset-price burst and the presence of debt overhang. The term "debt overhang" in this study refers to a situation when the total amount of debt exceeds the amount that can be repaid, and the repayment has not yet been completed. Conversely, default signifies that the repayment of debt has been officially resolved and the financial institution has disregarded the outstanding amount. The presence of debt overhang in our model is inherently inefficient following a collapse in asset prices, as the asset functions as theinput forproduction.
This research also aims to present a demand-side viewpoint on financial crises. Our research diverges from the current body of literature in three distinct aspects. The first factor is the origin of inefficiencies. Our research centers on the issue of debt overhang, which serves as a deterrent for borrowers to engage in new projects and diminishes the demand for more credit. In contrast, the majority of existing studies primarily examine the monetary externalities resulting from borrowing limitations and coordination failures, such as bank runs. The subsequent aspect pertains to the cascading mechanism of inefficiency. In our model, the presence of debt overhang serves as a deterrent to production activities, leading to a subsequent lack in demand, so exacerbating this inefficiency. On the other hand, the deficiencies observed in financial crises as documented in the current body of literature are primarily magnified by a rise in credit costs or a scarcity of liquidity supply, rather than a shortfall of demand, resulting from financial frictions, sometimes referred to as credit crunch. The subsequent aspect pertains to policy initiatives. The contemporary research does not place significant emphasis on ex-post policies, such as government subsidies to banks to facilitate debt restructuring. Instead, it primarily focuses on the temporal inconsistency that results from ex-post bailouts. The ex-post debt restructuring policy played a significant role in addressing financial crises, such as the Global Financial Crisis (i.e. GFC) in 2008 and the recessions experienced in Japan during the 1990s. This paper argues that after the fact debt restructuring has a positive impact on welfare by reducing the aggregate demand externality. Additionally, it suggests that time inconsistency might not have significant effects in certain situations.
This paper encompasses the following activities. The present study develops a straightforward two-period model that integrates the risk-shifting booms about asset prices model (Allen and Gale, 2000; Allen, Barlevy, and Gale, 2022) with the macroeconomic debt overhang model resulting from spillover effects through aggregate demand (Lamont, 1995). This model aims to elucidate the productivity declines that occur following the collapse of asset prices. The crucial factor that allows for the integration of the two theories is our premise that the high-risk asset, whose value can be influenced by changes in risk, is also utilized as a resource for production by theborrower that may experience a burden of debt. Our analysis demonstrates that a modest value of AH, which represents the level of optimistic expectations, leads to a low asset price and the absence of both debt overhang and recession in equilibrium. This scenario is commonly referred to as the Normal Equilibrium (NE). When the aggregate supply (AH) is substantial, it gives rise to what is known as the Debt Overhang Equilibrium (DOE), wherein the initial price of the asset is elevated, but subsequently declines if the asset's productivity is shown to be poor. The decline in asset prices is subsequently followed by a recession caused by an excessive burden of debt.
In the Department of Energy (DOE), the price of an asset is increased by investors who purchase the asset using borrowed funds. The borrowers increase the price of the asset to impose further costs on the lenders by defaulting upon the debt if the asset's productivity is insufficient. This refers to the phenomenon of asset values experiencing a significant increase in risk (Allen & Gale 2000; Allen, Barlevy, and Gale 2022). Due to the massive inflation caused by borrowing investors, it is quite probable that the asset price would fall. The reduction in asset prices leads to an increase in debt and a disproportionate decrease in total factor productivity (TFP) due to the deterrent effect of debt overhang on borrowing investors' willingness to allocate resources. The individuals in question experience a sense of demotivation due to the lenders' inability to guarantee compensation for their endeavours, as the lenders possess the lawful authority to demand the entirety of the debt, provided that it exceeds the borrowers' income (Kobayashi, Nakajima, & Takahashi, 2022). In conjunction with the burden of debt resulting from lenders' insufficient commitment, there is a consequential impact on our economy through the reduction of aggregate demand in the context of monopolistic competition, commonly referred to as an overall demand externality. The concept of aggregate demand externality refers to the impact of a firm's withdrawal or entry on the revenues of other firms, resulting in a loss or increase in aggregate demand. The aggregate demand externality in our model arises from the inherent inclination towards variation within the Dixit-Stiglitz market of monopolistic competition. This externality serves as a deterrent for a corporation to sustain its production activities when other enterprises choose to depart the market due to excessive debt burdens. The excessive demand for goods and services leads to a decrease in overall economic productivity.
Additionally, it has been demonstrated that a more significant increase in asset prices can result in a more severe economic downturn. When the asset price boom is larger during the initial period, the consequent debt burden caused by the decline in asset prices becomes larger. This leads to a greater number of firms leaving the market, resulting in lower overall productivity. This is because the total factor productivity (TFP) in monopolistic competition decreases as the number of firms exiting decreases.
In our current configuration, there is an aggregate demand externality present, as the extent of debt reduction falls below the socially desirable threshold as determined by our model. Hence, implementing a policy intervention aimed at facilitating debt reduction has the potential to enhance welfare.To facilitate the process of debt restructuring, the government can provide subsidies to lenders, thereby partially compensating for the loss incurred from debt write-off. This approach aims to achieve the most optimal level of debt reduction. The findings of our study suggest that debt forgiveness has a positive impact on the productivity of borrowers, which aligns with the findings of Caballero, Hoshi, and Kashyap (2008). It is emphasized that zombie enterprises characterized by a significant debt burden are inherently inefficient & should be subject to liquidation. The findings of our study suggest the potential existence of zombie enterprises that can regain productivity through the forgiveness of their debts. In addition, our findings demonstrate that the implementation of ex-post policies aimed at facilitating debt restructuring doesn't inherently skew ex-ante incentives. Specifically, the issue of time inconsistency may not occur when ex-post policies include providing subsidies to lenders, while overall ex-ante allocation is determined by borrowers.
The government debt or tax may be used to support the subsidy towards banks engaged in debt restructuring. The act of debt restructuring, accompanied by subsidies provided to lenders, can be understood as a policy measure aimed at bank recapitalization, typically implemented in reaction to thefinancial crisis. The provision of bank subsidies to support restructuring debt is a fiscal policy measure that aligns with the principles of active fiscal policies in the context of low-interest rates following the Great Recession (Blanchard, 2019).
Literature Review
There exists a substantial body of empirical literature that documents empirical regularities about asset-price and credit booms, as well as their subsequent impacts on economic growth. One notable study conducted by Jorda, Schularick, & Taylor (2015) examines data from 17 nations over 140 years. Their findings indicate that asset-price booms, which are driven by credit booms, often culminate in financial crises, subsequently leading to prolonged and severe recessions. According to Greenwood, Hanson, Shleifer, and Srensen (2021), a significant increase in private credit & asset values is indicative of an impending financial catastrophe.
There exists a body of literature suggesting that credit booms in isolation can pose challenges to economic performance. Schularick & Taylor (2012) analyze data from 14 nations spanning 140 years. Their findings indicate that credit booms tend to result in financial crises. According to Giroud and Mueller (2021), there is a correlation between an increase in business leverage and a cyclical pattern of employment growth and decline. It has been demonstrated that the long-term consequences of credit deepening and the short-term effects of credit booms have contrasting impacts on economic growth. According to King and Levine (1993), the process of credit deepening has been found to have a positive impact on long-term economic growth. Additionally, Verner (2019) has conducted a study analyzing data from 143 countries over 60 years. Verner's findings indicate that the expansion of credit supply typically fuels short-term credit booms and can result in financial crises.2 According to Justiniano, Primiceri, and Tambalotti (2019), the empirical evidence regarding the housing boom that occurred before the Great Recession aligns with the notion that the growth was primarily driven by an expansion in credit supply rather than theincrease in credit demand. Mian, Sufi, and Verner (2017) have also documented the negative impact of a credit supply shock. The findings demonstrate that a shock in credit availability leads to a reduction in the interest rate and an escalation in household debt during periods of increased expenditure, subsequently resulting in a sustained decline in GDP growth. Gorton and Ordonez (2020) have conducted research that highlights the differentiation between favourable credit expansions accompanied by robust economic growth and unfavourable credit expansions accompanied by sluggish growth. According to Muller and Verner (2023), their analysis of data from 116 nations for 80 years reveals that instances of bad credit booms primarily manifest as debt booms inside the non-tradable sector.
It is widely recognized that financial crises often coincide with a sustained deceleration in productivity. According to Duval, Hong, and Timmer (2020), it is posited that the significant decline in productivity observed throughout the Great Recession could potentially be attributed to financial frictions. Adler et al. (2017) indicate a significant decline in productivity growth following the Global Financial Crisis (GFC).3 The relevant literature focuses on the great depressions, which are long-lasting economic downturns that occurred during the 20th century. According to Hayashi and Prescott (2002) and Kehoe and Prescott (2002), it has been suggested that the primary factor contributing to the great depression is the occurrence of profound and enduring decreases in productivity. According to Caballero, Hoshi, and Kashyap (2008), zombie lending leads to decreased productivity as inherently inefficient firms can thrive due to the presence of zombie lending. According to Nakamura and Fukuda (2013), a considerable proportion of non-tradable sector firms that experienced challenges in repaying debt during the 1990s have since rebounded and demonstrated productivity in the 2000s. This suggests that zombie enterprises burdened with debt may not have been inherently unproductive. This implication aligns with our theoretical framework, which posits that the efficiency of a corporation can be enhanced by the forgiveness of debt overhang.
Risk Shifting Effect: The present study is connected to the existing body of work on the phenomenon of risk-shifting booms in asset values, as examined by Allen & Gale (2000) and Allen, Barlevy, and Gale (2022). The authors illustrate that the occurrence of asset-price bubbles can be attributed to the phenomenon of risk shifting when investors acquire assets with borrowed funds. In their models, the price of default is determined by external factors and there is no possibility of a policy response after the fact. However, in our model, reducing debt after the fact can help minimize the inefficiency. Our theoretical framework is similarly connected to the work of Biswas, Hanson, and Phan (2020), wherein the occurrence of a collapse in the asset-price bubble leads to a prolonged recession. This recession is further exacerbated by the presence of nominal wage rigidity. However, it is important to note that their model does not incorporate any ex-post policy action.
Debt Overhang: According to our theoretical framework, the asset, specifically the capital stock, serves as an input for production. However, the efficiency of production is compromised as a result of debt overhang, which arises from the collapse of asset prices. Therefore, our research is connected to the extensive body of literature on debt overhang. According to the research conducted by Kobayashi, Nakajima, and Takahashi (2023), debt overhang might be classified into two distinct categories. The initial form of debt overhang arises from the absence of borrowers' dedication, whereas the subsequent form arises from the absence of lenders' dedication. The debt burden described in this research pertains to the second category. Studies such as Albuquerque & Hopenhayn (2004), Kovrijnykh & Szentes (2007), & Aguiar, Amador, and Gopinath (2009) have examined the first form of debt overhang. The inefficiency in these models arises from the lenders' provision of a back-loading payoff schedule to the borrowers, to mitigate the risk of early borrower default. Kobayashi et al.,(2023) have put up arguments on the second category of debt overhang. In the second category, inefficiency occurs when borrowers opt not to exert effort due to the lenders' inability to guarantee their exertion. The absence of lenders' dedication can be attributed to the lenders' legitimate entitlement to seize all assets when the debt exceeds the borrowers' income. In this scenario, the lenders lack the credibility to commit to providing borrowers with positive sums as a means of acknowledging and rewarding their efforts.
Aggregate Demand Externality: According to Korinek & Simsek (2016) & Farhi & Werning (2016), there are hypotheses suggesting that financial crises and subsequent recessions can be attributed to the concept of "aggregate demand externality," which differs from our definition. Financial crises in their models result in inefficient redistribution due to the zero lower limit and nominal rigidities, which lead to the shift of income from borrowers to savers with a lower marginal propensity to spend (MPC). In their models, the demand-side externality refers to the externality that occurs when the combination of the zero-level lower limit and nominal rigidity leads to a reduction in aggregate demand by transferring it to agents with lower marginal propensity to consume (MPC). The presence of an aggregate demand externality can be attributed to the presence of nominal rigidities in their models, but in our model, it is primarily caused by monopolistic competition as well as debt overhang. Lamont (1995) posits a comparable externality to our aggregate demand externality, albeit without the inclusion of business exits in Lamont's model. In contrast, our model includes endogenous firm departures, which result in a decrease in productivity.
Theoretical studies over policy responses and financial crises: This study pertains to the extensive body of scholarship concerning financial crises and the subsequent policy actions. The distinction between our model and previous studies may be elucidated through three key dimensions: the origin of inefficiencies, the characteristics of inefficiency, and the correlation between pre- and post-policy interventions. The existing body of literature predominantly examines the origins of inefficiency, with a particular emphasis on pecuniary externality resulting from borrowing constraints (Aguiar and Amador 2011; Benigno et al. 2023; Bianchi 2011, 2016; Bianchi as well Mendoza 2010; Farhi, Golosov, and Tsyvinski 2009; Gertler, Kiyotaki, as well as Queralto 2012; Lorenzoni 2008; Lorenzoni and Werning 2019) and coordination failures such as bank runs (Diamond and Dybvig 1983; Gertler & Kiyotaki 2015; Keister 2016; Keister &Narasiman 2016). However, the primary cause of inefficiency in our model is the presence of debt overhang. This can arise due to a range of factors, including news shocks, asset bubbles, and overconfidence, even in the absence of external financial constraints or coordination failures. Furthermore, in relation to the characteristics of inefficiencies, numerous current models exhibit allocative inefficiencies in the allocation of consumption (Bianchi 2011;Farhi, et al.,2009; Chari & Kehoe 2016;Jeanne &Korinek 2020; Keister 2016) or inefficient production resulting from the rise in credit costs, commonly referred to as the credit crunch (Bianchi 2016; Bianchi and Mendoza 2010; Gertler, Kiyotaki, and Queralto 2012; Lorenzoni 2008). In contrast to the aforementioned models, our model exhibits inefficient production as a result of scarcity in both aggregate demand and credit demand. Regarding policy interventions, the current body of literature predominantly examines the trade-off that arises from bailout policies, specifically the trade-off between ex-ante incentives and ex-post efficiencies. This trade-off is commonly referred to as the time inconsistency. This perspective is supported by various scholars such as Bianchi (2016), Chari and Kehoe (2016), Green (2010), Keister (2016), and Keister and Narasiman (2016). According to Chari and Kehoe (2016), bailouts have the potential to diminish welfare due to the presence of time inconsistency. Conversely, Bianchi (2016), Green (2010), Keister (2016),and Keister &Narasiman (2016) contend that the welfare-enhancing impacts of bailout policies outweigh the negative consequences of time inconsistency. Our model demonstrates that the temporal inconsistencies of theex-post policy cease to exist, and only welfare-enhancing effects persist in certain scenarios when the ex-post policy takes the form of subsidies to lenders, but the ex-ante allocation is determined by borrowers.
