Towards a microeconomic theory of the finance-driven business cycle

Abstract

I sketch a program for a microeconomic theory of the main component of the business cycle as a recurring 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 2007-08 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.

6 pages, no figures. Presented at 1st International Congress on Actuarial Science and Quantitative Finance, Bogotá, Colombia, 20 Jun. 2014. v2: References updated and improved, some points clarified, matches published version