For a macroeconomist working to construct a theoretical structure for understanding the economy as a whole, debt is either trivial or intractable. Trivial because (in a closed economy) it is net zero – the liabilities of all borrowers always exactly match the assets of all lenders. Intractable because a full understanding of debt means grappling with a world in which the choice between debt and equity matters in some fundamental way. That means confronting, among other things, the intrinsic differences between borrowers and lenders; non-linearities, discontinuities, and constraints in which bankruptcy and limits on borrowing are key; taxes, where interest paid to lenders is treated differently from dividends paid to shareholders; differences between types of borrowers, so household, corporate and government debt are treated separately; and externalities, since there are times when financial actors do not bear (or are able to avoid) the full costs of their actions.The mind reels - they are just starting to think about how to include debt in their models now?
As modern macroeconomics developed over the last half-century, most people either ignored or finessed the issue of debt. With few exceptions, the focus was on a real economic system in which nominal variables – prices or wages, and sometimes both – were costly to adjust. The result, brought together brilliantly by Michael Woodford in his 2003 book, is a logical framework where economic welfare depends on the ability of a central bank to stabilise inflation using its short-term nominal interest rate tool. Money, both in the form of the monetary base controlled by the central bank and as the liabilities of the banking system, is a passive by-product. With no active role for money, integrating credit in the mainstream framework has proven to be difficult.
Yet, as the mainstream was building and embracing the New Keynesian orthodoxy, there was a nagging concern that something had been missing. On the fringe were theoretical papers in which debt played a key role, and empirical papers concluding that the quantity of debt makes a difference.
The latest crisis has revealed the deficiencies of the mainstream approach and the value of joining those once seen as inhabiting the margin.
Friday, August 26, 2011
From Stephen Cecchetti's paper at the Jackson Hole conference.