By leaving the dynamics of information out of the account, neoclassical economic theory reduces finance to a mere veil between lenders and borrowers, without significant macroeconomic consequences. On the other hand, experience indicates that the gravest macroeconomic fluctuations are associated with a financial dynamic, as has been stressed by heterodox economists from quite diverse schools of thought. In this talk I will outline a theory of an endogenous business cycle resulting from an instability caused by incompleteness of the financial markets and information asymmetries between lenders and borrowers. This provides a microeconomic explanation of Keynes's otherwise mysterious "excessive saving" while challenging the wisdom of traditional Keynesian policies and renewing the debate on what might be a free-market solution to the problem of financial instability.

1. Debt & Disequilibrium
UFM Market Trends
Guatemala
23 March 2017
1
Alejandro Jenkins

2. 2
Les querelles ne dureraient pas longtemps,
si le tort n’était que d’un côté.
– La Rochefoucauld, maxime 496

3. Usury
Da queste due,* se tu ti rechi a mente
lo Genesì dal principio, convene
prender sua vita e avanzar la gente;
e perché l’usuriere altra via tene,
per sé natura e per la sua seguace
dispregia, poi ch’in altro pon la spene.
– Inferno XI
* (natura e arte)
•Weber: prevalence of debt slavery →
Abrahamic prohibition of interest
3
Dalí, The Usurers (1951-60)

4. Interpretations of the Great
Depression
• Hayek: monetary expansion
induced malinvestment
• Keynes: excessive saving
depressed aggregate
demand
• Schumpeter: adjustment of
the market to technological
change and other
exogenous shocks
4

5. Great Depression, cont.
• Fisher: debt need not be
macroeconomically neutral
• Schumpeter, Friedman,
Tobin: “greatest economist
the US has ever produced”
• Smith: “A student once
asked Leontief why there
was no Fisherian school.
Leontief said: ‘He wrote too
clearly’.”
5
Irving Fisher
(1867-1947)
Vernon L. Smith
(n. 1927)

6. 6
Rien ne persuade tant le gens qui ont peu
de sens, que ce qu’ils n’entendent pas.
– Retz, Mémoires III

7. Equilibrium
• In microeconomics, efficient outcome is one in
which all possible gains from voluntary exchange
are realized
• No one could be better off without making another
worse off
• Also Pareto optimality or, in a pricing context,
general equilibrium
• Refers only to exchange
7

8. Equilibrium, cont.
• Worked out by Fisher,
Samuelson et al. by analogy
with thermodynamic
equilibrium
• Directly influenced by
statistical mechanics of
Willard Gibbs (1839 - 1903)
• Arrow-Debreu welfare
theorems (1951, 59) assume
complete markets & perfect
information
8

9. Assets
• Consumption market: good or
service exchanged once (e.g.,
hamburgers, haircuts)
• Asset market: same good
exchanged many times (e.g.
capital stock, real state)
• Bachelier (1900), Mandelbrot
(1963) & Samuelson (1965)
showed the efficiency asset
prices follow random walks
(sub-martingales)
9

10. Assets, cont.
• Smith et al. find experimentally
that consumption markets
equilibrate very robustly
• Not the case for assets
• Debate on asset market
efficiency reflected in 2013
Nobel Prize for Fama, Hansen
& Shiller
• In an efficient asset market,
risks would be correctly
estimated
10
Fuente: http://www.uchicago.edu/features/
what_makes_nobel_speeches_endure/

11. Modigliani-Miller (1958)
• In equilibrium, firm’s value must be independent of its
capital structure
• Investor could cancel her share of the firm’s debt with
money borrowed on her own account, without gaining or
losing anything (no arbitrage)
• “In retrospect, it is clear that macroeconomists —both
inside and outside central banks— relied too heavily
during that period on variants of the so-called Modigliani-
Miller theorem, an implication of which is that the details
of the structure of the financial system can be
ignored when analyzing the behavior of the broader
economy.” – Ben Bernanke, 2013
11

12. Monetary paradox
• Friedman rule: in equilibrium, private opportunity cost
of holding liquidity should equal social cost of
providing it
• Cost to central bank of providing liquidity is negligible
• → optimum would be 0% nominal rate on riskless
bond
• → deflation equal to real interest rate
• Not even Friedman took this seriously as policy (cf. his
“k-percent rule”)
12

13. 13
My pulse, as yours, doth temperately keep time,
And makes as healthful music: it is not madness
That I have utter’d.
– Hamlet III, 4

14. • “If statistical observation leads us to believe that a given
magnitude varies periodically, and if we look for the cause of
those oscillations, we may suppose that that magnitude
executes either
• (a) forced oscillations, or
• (b) self-oscillations, which may be either sinusoidal [weakly
nonlinear] (bα) or of relaxation type [strongly nonlinear] (bβ).”
- Econometrica 1, 328 (1933)
14

15. Self-oscillation
15
http://www.youtube.com/watch?v=eAXVa__XWZ8
Credit: M. de Pablo

16. his article appeared in a journal published by Elsevier. The attached
opy is furnished to the author for internal non-commercial research
nd education use, including for instruction at the authors institution
• AJ, “Self-Oscillation”, Phys. Rep. 525,
167 (2013), [arXiv:1109.6640
[physics.class-ph]]
• Micro-dynamics of markets totally
different from physical systems
• …but uses & limitations of
macroscopic equilibrium have
similarities in statistical mechanics
and economics
• AJ, “Towards a Microeconomic Theory
of the Finance-Driven Business
Cycle”, Laissez-Faire 42, 12 (2015) +
refs.
16
https://arxiv.org/abs/1312.0323

17. Edward Hopper, The “Martha KcKeen” of Wellfleet, oil on canvas (1943)
Museo Thyssen-Bornemisza, Madrid
17

18. Rayleigh - van der Pol
10 20 30 40 50 60
t
-2
-1
1
2
V
V (0) = 0.1 , ˙V (0) = 0
10 20 30 40 50 60
t
- 3
-2
-1
1
2
3
4
V
V (0) = 4 , ˙V (0) = 4
¨V 0.2 1 V 2 ˙V + V = 0
18

19. Relaxation
5 10 15 20 25 30
t
-2
-1
1
2
V
V (0) = 0.1 , ˙V (0) = 0
5 10 15 20 25 30
t
-2
-1
1
2
V
V (0) = 2.2 , ˙V (0) = 12
¨V 5 1 V 2 ˙V + V = 0
19

20. Macro models
• Linearly unstable relation between income,
capital & investment introduced in 1930s by
Kalecki, Hansen & Samuelson
• Non-linear models with relaxation limit cycles by
Goodwin, Kaldor, Hicks, et al.
• Lucas critique: anticipation of a regular cycle
would make it go away
• Is business cycle efficient?
20

21. Bubbles
• Self-driven, but unsustainable, rise in asset price
• V. Smith et al. easily generate bubbles in controlled
experiments, even with experienced traders
• Max Weber on Mississippi & South Sea Co.
bubbles (1710s): “can be explained only by the
fact that short selling was impracticable, since
there was as yet no systematic exchange
mechanism” (General Economic History, 1923)
• Incompleteness may persist in finance
21

22. 22
Relaxation oscillations are commonplace not only in
physics, but also in physiology (heart beats) and
economics (business cycles) as well. In fact, the
expression ‘history repeats itself’ is probably a
description of a large-scale integrated relaxation
oscillation phenomenon.
– Sargent, Scully & Lamb, Laser Physics (1978)

23. Ingredients
1. Leverage cycle
2. Liquidity crisis (financial panic)
3. Debt deflation
4. Debt overhang & flight to quality
5. Household deleveraging & liquidity trap
23

24. Leverage cycle
• John Geanakoplos (2010): market determination of
leverage for buying an asset on credit, as in mortgage
• More leverage allows more optimistic investors to set
price
• Higher asset price improves collateral, promoting
credit
• Positive feedback between leverage and price
24
leverage =
(purchase value down payment)
down payment

25. Leverage, cont.
• Credit default swaps (CDS)
complete market by allowing
pessimist to leverage their
bets.
• CDS standardized for US
secondary housing market
towards the end of 2005
• see The Big Short
25

26. Information
• Optimism & pessimism wouldn’t exist under perfect
info.
• Hayek, Stigler, et al. stressed that economically
relevant info. is not given, but emerges through
market process
• Absence of CDS pre-2006 relevant not just as
incompleteness per se
• Prevented info. held by pessimist potential investors
from being incorporated into asset prices in a timely
way
26

27. Liquidity crisis
• Bubble followed by rapid fall in asset prices
• Widespread defaults among leveraged buyers
• Losses to banks, which also carry asset in their balances
• Depositors withdraw funds, forcing hasty liquidations
(fire sale)
• Asset prices fall further; financial institutions may grow
illiquid
• Financial panic: joint defaults, counterparty credit risk,
etc.
27

28. Debt overhang
• Borrowers end up as owners of depressed asset; lenders end up
as owners of debt
• Wealth transfer from net borrowers (‘households’) to net lenders
(‘banks’)
• Fisher: net lenders have lower marginal propensity to consume
• Smith: borrowers may end up with negative equity (‘underwater’)
• → households can’t enjoy most of their new income
• Principal-agent problem between banks and households
causes investor’s flight to quality
28

29. Debt deflation
• Fractional reserve banking
causes spike in demand for
liquidity to contract monetary
supply (money’s ‘perverse
elasticity’)
• Deflation aggravates debt
overhang
• Can be combatted by
increased supply of liquidity
(quantitative easing)
29
(1936)

30. Keynesianism
• Debt overhang and principal-agent problem could
help explain Keynes’s excessive saving
• Underwater households can’t spend or invest at
normal levels
• → fall in aggregate demand
• Money paid to households goes quickly to bank
• Bank won’t lend back while household is
underwater → liquidity trap
30

31. Keynesianism, cont.
• Inflation relieves debt overhang, but has other
undesirable consequences
• Government’s deficit spending even more
problematic
cf. Eggertsson & Krugman (2012)
• Wiping out savers harmful in the long run, even if it
relieves crisis
31

32. 32
Source: S. D. Gjerstad y V. L. Smith, Rethinking Housing Bubbles
(Cambridge U. P., 2014), p. 258

33. Statistical mechanics
• Theoretical physics suffers very analogous blind spot
• ‘Non-equilibrium thermodynamics’ usually focused on
stochastic fluctuations about equilibrium
• Mostly fails to describe dynamics of engines (self-
oscillators)
• Engines are powered by external gradient of temperature
or chemical potential
• e.g., life on Earth maintained by temperature difference
between Sun’s surface (6,000 K) & Earth’s surface (300 K)
33

34. Debt dynamics
• People save some of their income, even at negative rates
• Banks exist because of info. problems in finding efficient use for
these savings
• Fisher & Rothbard’s mistake: Equilibrium yield curve (rate v.
term) not determined by deposit contracts alone
• There’s usually scope for arbitrage of terms
• i.e., pay low rate on short-term deposit one expects to be
renewed, while lending out that money at higher rates and
longer terms
• Why free markets disfavor 100% reserve banking
34

35. Debt dynamics, cont.
• Maturity mismatch makes liquidity crises possible,
but it’s partly a free-market phenomenon
• Financial markets probably remain far from
equilibrium
• This may explain many macroeconomic paradoxes
• Yield curve doesn’t translate into structure of
production (Hayek’s mistake)
35

36. Sustained non-equilibrium
• Savings analogous to
reservoir of chemical
energy in biological cell
• E. Moreno: “the economy is
alive”
• No savings → no business
cycle
• but also far lower living
standard!
36

37. 37
Confusion’s cure lives not
in these confusions
– Romeo & Juliet IV, 5

38. Outlook
• Post-2007 policies have responded only to liquidity
crisis & debt deflation (monetarism)
• Slow deleveraging of households has depressed
consumption & investment
• Worsened in Spain by “personal collateral” for
residential mortgages
• Uncertainly about regulatory, monetary, and fiscal
policies obstructs voluntary debt-relief negotiations
38

39. Outlook, cont.
• Bailing out “solvent but illiquid” financial institutions
involves grave risk of corruption
• e.g., deep & long-lasting damage to efficiency of
Japanese banking post-1992
• Monetary expansion (zero interest, quantitative
easing) meets banks’ elevated liquidity demand
• Inflation & deficit spending weakly focused on
problem of underwater households, while involving
grave unintended consequences
39

40. Solutions
• Regulate leverage? (Geanakoplos)
• Universalize margin requirements? Smith justifies it
as defining property rights when betting with
others’ money
• Simply completing financial markets?
• Shouldn’t be so much harder to bet against asset
• Smith: Owners of bad debts should face ‘haircuts’
40