Third element of doing modeling in financial fragility is the main feature, the main characteristic of any financial crisis – namely, of default. The role of endogenous default is crucial and critical for any attempt to model properly financial stability into economics.

Default to economics, or to macroeconomics more precisely, is what sin is to theology. It is regrettable, however central and important.

In fact, the role of endogenous default is the key channel and the key amplification mechanism that generates contagion and systemic risk in general.

Therefore the role of endogenous default is central and important in any attempt to model financial fragility. In other words, one should be able to incorporate both strategic default and default due to ill fortune in any economics framework that attempt to deal with financial crisis and financial stability more generally. Combined with financial intermediaries and the role of default and liquidity one has to understand that any economy has to be heterogeneous. Heterogeneity of actors and economic agents is always necessary if we want to be precise in our analysis and to be able to see how contagious crises are and what are the contagion channel and the systemic risk that impact upon the economy. Moreover, if one introduces heterogeneity in a very precise and analytically tractable way one can possibly make many arguments about welfare and prosperity of the economy and try to see which sectors of the macroeconomy are affected when an adverse financial shock hits the economy. Therefore if one has these four elements – namely, liquidity and money, default, commercial banks and heterogeneity one can properly model and can properly address the interaction of the nominal and the real sector, because if we are interested in financial stability we are interested because financial shocks are transmitted to the real economy and they have real welfare consequences for the economic agents involved.

These four elements allow us to introduce the minimal institutions that are necessary in order to address issues of financial stability to be able to make welfare statements and try to embed into economic models the necessary financial frictions that will allow us to see contagious effects of financial crises and systemic risk. More precisely, the necessary ingredient of a framework that purports to analyze financial stability is missing financial markets. So the concept that not all risks in the economy can be hedged with the existing assets and the existing financial instruments is what is referred to in economics as ‘missing financial markets’. And the importance of missing financial markets is that, first, it gives rise to inefficiencies, so the optimal solutions and the welfare cannot be maximized via the market system and, second, we are able to talk about endogenous default very precisely and see how it is established in equilibrium. In other words, if markets were complete and if all the risks could be held a priori there would be no role of default and then the cons of endogenous default could be if at all only strategic. However, it is exactly the fact that there are financial frictions and missing financial markets that makes default critical, important and not neutral in the economy. And each interaction between liquidity and default becomes very central to our analysis, because we may use that analogy that liquidity and default are the two sides of the same coin.

More importantly, when we have missing financial markets, in such a framework with minimal institutions is that the equilibria, or the resting points of the economy, are constrained Pareto suboptima. In other words, the economy doesn’t arrive at the first best, but it fact doesn’t even arrive at the second best. That means that regulatory policy, monetary policy, fiscal policy, government intervention in general has real effects and may generate welfare improvements in the economy. So missing financial markets, institutions and financial frictions are the characteristics that allow the assessment and the analysis of government policy, monetary policy and regulatory policy and therefore its interaction in order to be able to address financial fragility and the externalities that are generated due to adverse capital and financial shocks into the economy.

When we have such a framework, then we are in a position to systematically address the role of default and the role of regulation in each interaction in the economy. In other words, we are in a position to find, given the frictions we introduced into our way of thinking and to a market-based model of regulation and financial stability, the optimal default and bankruptcy code and the optimal regulatory mix. What does this mean? This means, since an economy with many externalities and many frictions produces many channels of inefficiencies, we are not able, only with one single monetary policy target or one single regulatory tool, to address all of those inefficiencies.

It is neither optimal nor necessary to employ only one regulatory tool or only one monetary policy to address increased default, and lower bank profitability, and adverse welfare effects in the economy.

Moreover, and more importantly, the optimal bankruptcy code and the optimal regulation is neither extremely lenient, nor extremely harsh. To give an example: the optimal default rule or the optimal default penalty in case if a nation abrogates its contractual obligations is not the most stringent default penalty or the most lenient penalty – for a simple reason that if the default code and the bankruptcy code is very very lenient nobody will ever pay back and nobody will fulfill his contractual obligations, and therefore the economy will come into a standstill. And on the other hand, if the default and the bankruptcy code is very very stringent that will decimate and kill the risk-taking behaviour of economic agents.

So the optimal default penalty should be somewhere in the middle of the range of possible bankruptcy rules. Thus, the optimal regulatory mix and the optimal interaction between monetary policy includes multiple macroprudential tools: for example, capital requirements, liquidity requirements, net state to fund ratios, loan to value ratios, marginal requirements, inheritance insurance and so forth, quantitative easing and other unconventional monetary policy rules. And the idea is, the whole concept is that we have multiple externalities, multiple inefficiencies, therefore we need multiple tools. And given the initials conditions of a particular economy the policy makers should optimally combine monetary and regulatory policies to achieve the best possible outcome for the economy. In this way, in effect, what I have just described, is a new, mathematical institutional economics whereby minimal institutions will be introduced into an otherwise canonical economic model in order to be able to address the repercussion and the amplification effects of default, banks, externalities and, above all, missing financial markets.

http://serious-science.org/liquidity-and-default-in-macroeconomic-growth-5981