Debt-Ridden Equilibria - A Simple Theory of Great Depressions -

The US Great Depression and Japan's Lost Decade in the 1990s are both characterized as persistent stagnations of economies with debt-ridden corporate sectors subsequent to asset-price collapses. We propose a simple model, in which increases in corporate debt, and/or fluctuations in expectations about the future state of the economy, can account for these episodes. Key ingredients are the assumptions that firms are subject to collateral constraint in borrowing their working capital, or liquidity, for financing the inputs and that firms can hold other firms' stocks as their assets and use them as collateral. That corporate stocks are used as collateral generates the following interaction between stock prices and productive efficiency: higher stock prices loosen the collateral constraint and lead to higher efficiencies in production, which in turn justify higher stock prices. We show that due to this interaction there exists a continuum of steady-state equilibria indexed by the amount of corporate debt: a steady state with a larger debt can be called a debt-ridden equilibrium, since it has more inefficient factor markets, produces less output, and is characterized by lower stock prices. There also exists indeterminacy in the equilibrium paths: since optimizations by agents alone cannot specify the path of the economy, the expectations which are exogenously given are necessary to uniquely pin down the equilibrium path. The model provides the policy implication that debt reduction in the corporate sector at the expense of consumers (or taxpayers) may be welfare-improving when firms are debt-ridden.