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 20141

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

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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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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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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• 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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Phare des Baleines (Lighthouse of the Whales) on Île de Ré. Source: Wikipedia7

Rayleigh - van der Pol

10 20 30 40 50 60 t

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2V

V (0) = 0.1 , V̇ (0) = 0

10 20 30 40 50 60 t

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-2

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2

3

4V

V (0) = 4 , V̇ (0) = �4

V̈ � 0.2�1� V 2

�V̇ + V = 0

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Relaxation oscillations

5 10 15 20 25 30 t

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2V

V (0) = 0.1 , V̇ (0) = 0

5 10 15 20 25 30 t

-2

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V

V (0) = 2.2 , V̇ (0) = �12

V̈ � 5�1� V 2

�V̇ + V = 0

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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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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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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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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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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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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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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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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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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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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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