I sketch a broad program for a microeconomic theory of the business cycle as a recurring episode of disequilibrium, driven by incompleteness of the financial market and by information asymmetries between borrowers and lenders. This proposal seeks to incorporate five distinct but connected processes that have been discussed at varying lengths in the literature: the leverage cycle, financial panic, debt deflation, debt overhang, and deleveraging of households. In the wake of the 2007 financial crisis, policy responses by central banks have addressed only financial panic and debt deflation. Debt overhang and the slowness of household deleveraging account for the Keynesian "excessive saving" seen in recessions, which raises questions about the suitability of the standard Keynesian remedies.

1. Towards a microeconomic
theory of the finance-
driven business cycle
Alejandro Jenkins
U. of Costa Rica
!
1st International Congress on Actuarial Science and
Quantitative Finance
Bogotá, Colombia
20 June 2014
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2. Salvador Dalí, The usurers (1951-60)
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[Nature and Art], if thou recall to mind
Creation’s holy book, from the beginning
Were the right source of life and excellence
To human-kind. But in another path
The usurer walks; and Nature in herself
And in her follower thus he sets at nought,
Placing elsewhere his hope.
!
- Dante, Inferno, canto XI

3. Speculative crises
• Crises in the broader sense of chronic unemployment, destitution,
glutting of the market and political disturbances which destroy
all industrial life, have existed always and everywhere.!
• But there is great difference between the fact that a Chinese or
Japanese peasant is hungry and knows the while that the Deity is
unfavorable to him or the spirits are disturbed and consequently
nature does not give rain or sunshine at the right time, and the fact
that the social order itself may be held responsible for the crisis,
even to the poorest laborer.!
• In the first case, men turn to religion; in the second, the work of men
is held at fault and the laboring man draws the conclusion that it
must the changed.!
• Rational socialism would never have originated in the absence of
crises.!
• — Max Weber, General Economic History (1923)
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4. Efficiency of asset markets
• Arrow-Debreu welfare theorems assume complete
markets and perfect information
• Bachelier, Mandelbrot & Samuelson showed efficient
asset prices are random walks (submartingales)
• Vernon Smith et al. find experimentally that
consumption, but not asset markets, equilibrate very
robustly
• Debate over efficiency of asset markets highlighted by
2013 Nobel Prize for Fama, Hansen & Shiller
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5. Self-oscillation
• “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
or of relaxation type.”
• - P. E. Le Corbeiller, Econometrica 1, 328-332 (1933)
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6. This article appeared in a journal published by Elsevier. The attached
• AJ, arXiv:1312.0323 [q-fin]
• AJ, “Self-Oscillation”, Phys. Rep.
525, 167-222 (2013), [arXiv:
1109.6640 [physics.class-ph]].
• AJ, The Physical Theory of Self-
Oscillators (in preparation)
• Micro-dynamics of physical
systems and markets are totally
different
• But uses and limitations of
macroscopic equilibrium bear
similarities
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7. Phare des Baleines (Lighthouse of the Whales) on Île de Ré. Source: Wikipedia
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8. 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
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9. Relaxation oscillations
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
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10. Macroeconomic models
• Linear models with unstable relation between
income, capital and 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 the business cycle an efficient outcome?
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11. Speculative bubbles
• Self-reinforcing but ultimately unsustainable surge in
asset price
• Smith et al. easily generate bubbles in controlled
experiments, even with experienced traders
• Weber on the great Mississippi and South Sea
Company bubbles of the 1710s: “can be explained only
by the fact that short selling was impracticable, since
there was as yet no systematic exchange mechanism.”
• Incompleteness may now lie in finance
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12. Leverage cycle
• Work by John Geanakoplos (2010) on market determination of leverage for
buying an asset on credit, as in mortgages!
• leverage = (purchase value - down payment) / down payment!
• (cf. Dr. Mercurio’s talk on derivative pricing under collaterization)
• Greater leverage allows asset to be bought up by more optimistic investors
• Positive feedback between leverage and price
• Naked credit default swaps (CDS) complete market by allowing pessimists
to leverage their bets
• CDS standardized for US residential mortgages in late 2005
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13. Information
• Optimism and pessimism wouldn’t exist under perfect
information
• Hayek, Stigler et al., have stressed that economically relevant
information isn’t a given
• Emerges through market process itself
• Lack of CDS pre-2006 relevant not just an incompleteness per
se
• May have prevented information possessed by more
pessimistic potential investors from being incorporated into
asset prices in a timely way
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14. Financial panic
• Bubble followed by steep decline of asset prices, causing many
leveraged buyers to default
• Loss for lenders, who also hold the asset on their balance sheets
• Depositors rush to withdraw funds, triggering “fire sale”
liquidations
• Prices fall further; many financial institutions may become
illiquid!
• Joint defaults, counterparty credit risks, etc.
• (cf. Prof. Jeanblanc’s course on modeling credit risk)
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15. Debt overhang
• Borrowers left as owners of depressed asset
• Lenders left as owners of debt
• Wealth transfer from net borrowers (“households”) to
net lenders (“banks”)
• Borrowers’ equity may become negative
(“underwater”)
• Principal-agent problem between banks and
households causes “flight to quality” by banks
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16. Debt deflation
• Irving Fisher in the 1930’s stressed that debt need not
be macro-economically neutral !
• Because of fractional reserve banking, a spike in
demand for liquidity contracts the money supply
(“perverse elasticity”)
• Unanticipated deflation worsens debt overhang
• Deflation may be combated by creating new money to
meet increased liquidity demands (quantitative
easing)
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17. Revisiting Keynes
• Debt overhang may explain Keynesian “excessive saving” and
“liquidity trap”
• Underwater households cannot spend or invest at usual level,
causing fall in aggregate demand!
• Money paid to households goes to paying down debt
• Banks won’t lend as long as households remain underwater
• Deficit spending and inflation may help, but can’t focus on
underlying problem and may create new distortions
• cf. Eggertsson and Krugman (2012)
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18. Summary
• Some macro fluctuations may be efficient responses to
changes in preferences and external circumstances (“real
business cycle”)
• Most severe fluctuations endogenous and inefficient!
• Associated with incomplete financial markets and principal-
agent problem between borrowers and lenders
• C. Borio “The Financial Cycle and Macroeconomics: What Have
We Learned?” (BIS Working Paper, 2012);
• S. Gjerstad and V. Smith, Rethinking Housing Bubbles,
(Cambridge U. P., 2014)
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19. Outlook
• Should leverage be regulated?
• Is it enough to complete financial markets?
• Policy responses post-2007 have addressed only
financial panic and debt deflation!
• Household deleveraging has been painfully slow
• Why do we see so little voluntary debt relief?
• Merits of deficit spending are unclear
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