__________________________________________________________________ Alejandro Jenkins Towards a Microeconomic Theory of the Finance-driven Business Cycle Introduction The business cycle is the recurrence of large macroeconomic fluctuations about the long-term growth trend in a market economy . Understanding this phenomenon is a central and longstanding problem in economic theory . It is also a question of great political significance in the modern world . Finance fulfills the useful function of transferring the control of capital from those who own it to those who can put it to productive use . The vastly higher standard of living of industrialized countries compared to more traditional societies would be impossible without private finance . There is , however , a widespread and longstanding sense that the most severe fluctuations in free market economies are driven by an instability associated with financial speculation . 1 1 M . Weber , General Economic History , trans . F . H . Knight ( Mineola , NY : Dover , 2003 [ 1923 ]), Chapter XXIV . Alejandro Jenkins ( Ph . D ., Caltech , 2006 ; A . B ., Harvard , 2001 ) is a member of Costa Rica ’ s National Academy of Sciences . He is currently an invited professor at the University of Costa Rica ’ s physics department . In the past he has worked as a research associate at Caltech , MIT , and Florida State University . The evidence of business cycles is clear , but the phenomenon has proved challenging to comprehend theoretically . One reason is that , if applicable , the microeconomic equilibrium theorems would rule out the kind of miscoordination between economic agents that seems to mark the most severe crises . Those theorems assume that markets are complete ( so that all possible voluntary transactions can be carried out ) and that all agents enjoy perfect information . 2 Those conditions are obviously not achieved in practice , but markets usually equilibrate quite well under more realistic circumstances , both in the real world and in controlled experiments . 3 Some macroeconomic fluctuations are undoubtedly caused by the market ‟ s response to exogenous shocks . 4 Credit re- 2 K . J . Arrow , “ An Extension of the Basic Theorems of Classical Welfare Economics ,” Proceedings of the Second Berkeley Symposium on Mathematical Statistics and Probability ( Berkeley : University of California Press , 1951 ), pp . 507-532 ; G . Debreu , Theory of Value ( New Haven : Yale University Press , 1987 [ 1959 ]). 3 V . L . Smith , Rationality in Economics ( Cambridge : Cambridge University Press , 2008 ). 4 R . E . Lucas , Jr ., Models of Business Cycles Laissez-Faire , No . 42 ( Marzo 2015 ): 12-20

__________________________________________________________________ strictions can amplify the effects of such shocks , 5 but even then the welfare cost of the fluctuations might be insufficient to justify interventionist stabilization policies . 6 On the other hand , the largest of the macroeconomic fluctuations associated with episodes of financial panic followed by high unemployment and political disturbances seem to be endogenous and inefficient . In order to understand what could drive such fluctuations , and how to alleviate them , it is necessary to understand just why and how financial markets may sometimes fail to equilibrate . Here I shall sketch , in broad outline , a program for a microeconomic theory of the business cycle , i . e ., for an understanding based on the choices made by rational agents . In this view , the business cycle , or at least a major component of it , appears as a recurring market inefficiency driven by incompleteness of financial markets and by information asymmetries between borrowers and lenders . This proposal brings together five distinguishable but connected processes . Previous researchers have treated each of these , though , to my knowledge , they have not articulated them as a coherent theoretical framework for the business cycle as a whole . These processes are : ( 1 ) the leverage cycle , ( 2 ) financial panic , ( 3 ) debt deflation , ( 4 ) debt overhang , and ( 5 ) deleveraging of households . ( New York : Basil Blackwell , 1987 ). The application to the business cycle of ideas taken from the mathematical sciences of control theory , non-linear dynamics , and non-equilibrium thermodynamics has a long but not very fruitful history . 7 I believe that the basic shortcoming of such efforts has been the absence of an adequate microeconomic foundation , which is what a physical scientist is least likely to contribute . I have nonetheless been motivated to draw up this “ memorandum ” by the sense that the separate strands of what could be a satisfactory understanding of the financedriven business cycle exist already , but are not being drawn together in a wholly satisfactory way by economists . Moreover , the policy implications of such a theory could be significant , but I have not seen them clearly articulated in the public debates that have followed the financial crisis of 2007-08 . Of existing strands of macroeconomic thought , the most relevant to this work is traceable to Irving Fisher ( 1867-1947 ), the first theorist to stress that debt need not be macroeconomically neutral . 8 Hyman Minsky has pursued this idea within a post-Keynesian framework . 9 More recently , Claudio Borio has proposed a “ financial cycle ” as the driver of the big- 7 For a review of the relevant literature , and some earlier comments of my own on the business cycle , see A . Jenkins , “ Selfoscillation ,” Physics Reports , 525 ( 2013 ): 167-222 . 5 N . Kiyotaki and J . Moore , “ Credit Cycles ,” Journal of Political Economy , 105 ( 1997 ): 211-248 . 6 P . Krusell et al ., “ Revisiting the Welfare Effects of Eliminating Business Cycles ,” Review of Economic Dynamics , 12 ( 2009 ): 8 J . Tobin , “ Irving Fisher ( 1867-1947 ),” in J . Eatwell , J . M . Milgate and P . Newman ( eds .), New Palgrave Dictionary of Economics ( London : Macmillan , 1987 ), vol . 2 , pp . 369- 376 . 9 H . Minsky , Stabilizing an Unstable Econo- 393-404 . my ( New York : McGraw-Hill , 2008 [ 1986 ]). __________________________________________________________________ 13

__________________________________________________________________ gest macroeconomic fluctuations . 10 Steven Gjerstad and Vernon Smith ( who have had the most direct influence on my own thinking ) have explored similar ideas , with a particular focus on residential mortgages . 11 Leverage Cycle It is widely recognized that asset markets ( in which the same good may be purchased and sold many times ) are susceptible to speculative bubbles , in which prices rise well above the fundamentals because of a self-reinforcing but finally unsustainable expectation that prices will continue to rise . This process ends with a rapid collapse of the asset price . Despite the widespread recognition that this phenomenon has recurred throughout history , the microeconomic theory of why such bubbles occur and how they may harm the economy as a whole remains incomplete and contentious . That self-reinforcing fads should cause temporary spikes in the prices of some assets may not require an explanation much deeper than the obvious psychological one . Nothing in the equilibrium theorems prevents people ‟ s preferences from changing over time . But the sheer size of certain speculative bubbles , and the serious damage that they can cause to the economy at large , pose major challenges for economic theory and policy . 10 C . Borio , “ The Financial Cycle and Macroeconomics : What Have We Learned ?” Journal of Banking & Finance , 45 ( 2014 ): 182- 198 . According to Max Weber ‟ s General Economic History , the great Mississippi Company bubble of the late 1710s “ can be explained only by the fact that short selling was impracticable since there was as yet no systematic exchange mechanism .” 12 That is , the bubble resulted from a market incompleteness that made it easier for optimists than for pessimists to bet on future price changes . Modernly , the relevant incompleteness probably lies in the financial market rather than the asset market itself : it is usually easier for optimists than for pessimists to leverage their bets ( i . e ., to make them with borrowed money ). As the price of an asset begins to climb , it may happen that it can be increasingly leveraged . As leverage increases , it takes a smaller up-front payment to acquire the asset . The marginal buyer , who sets the price , is therefore likely to be more optimistic about the price trend , making the price higher . Higher prices make the asset a more attractive investment , justifying optimism and leading to greater leverage . This positive feedback between leverage and asset price continues until they reach unsustainable levels and collapse . John Geanakoplos has developed a sophisticated model for this process . 13 Geanakoplos points out that in the run-up to the 2007-08 financial crisis , credit default swaps ( CDS ) did provide a mechanism to borrow money for betting against the housing market . ( A CDS is a negotiable contract that promises to compensate the buyer if some underlying financial instrument goes into default .) However , CDS ‟ s became widely availa- 12 Weber , op . cit ., p . 288 . 11 S . D . Gjerstad and V . L . Smith , Rethinking Housing Bubbles ( Cambridge : Cambridge 13 J . Geanakoplos , “ The Leverage Cycle ,” NBER Macroeconomics Annual , 24 ( 2010 ): University Press , 2014 ). 1-66 . __________________________________________________________________ 14

__________________________________________________________________ ble for US residential mortgages only in late 2005 , when the housing bubble was already well underway and approaching its peak . In those circumstances , the introduction of CDS ‟ s may have helped precipitate the crash . 14 A point worth highlighting is that the standard equilibrium theorems allow for differences in individual preferences , but not for differences of beliefs ( e . g ., of optimists versus pessimists ), which would not exist in a state of perfect knowledge . Hayek , Stigler , and other pioneers of the economics of information have emphasized that , in the real world , economically relevant knowledge is not a given , but rather emerges through the market process itself . 15 Therefore , the absence of CDS ‟ s in the housing market may have been significant not only as an incompleteness per se , but also because it prevented the information possessed by the more pessimistic potential investors from being incorporated into the asset prices in a timely way . Financial Panic When the growth phase of the leverage cycle ends with a rapid decline of asset prices , many of those who borrowed to purchase the asset are forced to default on their loans . Since the now depressed asset 14 Ibid . See also “ Discussion Summary of „ The Leverage Cycle ‟,” NBER Macroeconomics Annual , 24 ( 2010 ): 85-87 . usually serves as collateral for those loans , lenders suffer serious losses . Borrowers whose debts are now worth more than the collateral are especially likely to default . Furthermore , financial institutions often hold those same assets in their balance sheets . They are therefore suddenly faced with large accounting shortfalls and acute uncertainty about their ability to meet their obligations . A panic ensues in which other lenders ( e . g ., ordinary bank depositors ) withdraw their funds and financial institutions are forced to liquidate assets at “ fire sale ” prices , further depressing their market value . Many financial institutions may become illiquid and the financial sector as a whole may cease to function properly , doing immediate harm to the real economy . 16 Such a financial panic may be either alleviated or aggravated by financial regulations and government interventions . Since the early 20 th century , it has been widely accepted that one of the key roles of central banks is to act as lender of last resort , providing liquidity to distressed financial institutions that are actually solvent . 17 Nonetheless , some questions remain about how best to implement this in practice . It may be difficult for the lender of last resort , in the midst of a panic , to make fully rational decisions about which distressed institutions are merely illiquid ( so that loans are likely to be re- 16 S . Gjerstad and V . L . Smith , “ Monetary Policy , Credit Extension , and Housing Bubbles : 2008 and 1929 ,” Critical Review , 29 ( 2009 ): 269-300 . 17 B . S . Bernanke , “ Some Reflections on the Crisis and the Policy Response ” ( speech before the Russell Sage Foundation and The Century Foundation Conference on “ Rethinking Finance ”, New York , April 13 , 2012 ) ( http :// www . federalreserve . gov / newsevents / s 15 F . A . Hayek , “ Economics and Knowledge ,” in Individualism and Economic Order ( Chicago : University of Chicago Press , 1948 ), pp . 33-56 ; G . J . Stigler , “ The Economics of Information ,” Journal of Political Economy , 69 ( 1961 ): 213-225 and “ Imperfections in the Capital Market ,” Journal of Political Economy , 75 ( 1967 ): 287-292 . See also Smith , Rationality in Economics , pp . 61-68 . peech / bernanke20120413a . htm ). __________________________________________________________________ 15