Leverage and Asset Bubbles

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?