Leverage and Asset Bubbles
Averting Armageddon with Chapter 11? - Working Paper #182
The current financial crisis poses severe challenges for central bank policymaking; but the widely-used DSGE paradigm – designed to analyse the control of inflation – seems ill-suited to understanding the origins of the crisis or designing measures to resolve it.
The relevant macroeconomic framework must surely include high leverage and overvalued collateral assets, where capital restructuring is the key to crisis resolution. The usual ‘bankruptcy’ procedures for doing this are not designed to handle macro shocks hitting the whole economy : they would fail to internalise the price effects of asset ‘fire-sales’ required to satisfy margin calls. We use a simple model of creditconstrained borrowers to show how “super” Chapter 11 procedures can play a crucial role in preventing asset price correction triggering widespread economic collapse. (Timely cuts in interest rates – which act as transfers from lenders to borrowers – will also help.)
To cope with the financial shock, balance sheets need ‘restructuring’: what about the microfoundations of conventional macroeconomics?
About the Author
Initiative for Policy Dialogue (IPD)
Joseph E. Stiglitz is President of the Initiative for Policy Dialogue, and Chairman of the Committee on Global Thought at Columbia University. He is University Professor at Columbia, teaching in its Economics Department, its Business School, and its School of International and Public Affairs. He chaired the UN Commission of Experts on Reforms of the International Monetary and Financial System, created in the aftermath of the financial crisis by the President of the General Assembly. He is former Chief Economist and Senior Vice-President of the World Bank and Chairman of President Clinton’s Council of Economic Advisors. He was awarded the Nobel Memorial Prize in Economics in 2001.