Black Holes and Financial Crisis
Black Holes and Financial Crisis
Black Holes and Financial
Crisis: a narrow escape?
Talk based on:
‘Leverage and asset bubbles’
Marcus Miller and Joseph Stiglitz
CEPR DP September 2009
• Let firms use debt to buy assets at a time when
asset prices are on an expanding bubble.
• When the bubble bursts, this unleashes strong
contractionary forces: highly geared businesses
can easily slide into insolvency (liabilities
exceed assets) and end up being liquidated.
• Before looking at how these economic forces
can trap small business, consider an analogous
‘trap’ – not in economics but in in cosmology.
Cosmology: Black Holes
• When a supernova runs out of energy and
begins to collapse, its density may become so
great that it prevents light rays from escaping.
• So the dying star becomes a black hole: though
invisible, it can be detected by how it distorts the
space around it.
• [Stephen Hawking showed that, as black holes
emit radiation, they should finally disappear. ]
…there’s a black hole in there
Light bends and spaceman disappears
into black hole
Man-made Black Holes?
• Economies seem to have black holes too!
• Richard Koo describes how - when the gigantic
asset bubble burst in 1990 - many Japanese
businesses were dragged into insolvency as
their assets fell below the value of their debts.
• The efforts of firms to sell assets to pay down
their debts only seemed to make things worse …
Why should insolvency matter?
• ‘If it becomes known that a borrower is
technically insolvent, loans extended to the
company will become bad loans and the lender
will be forced by government regulators to cut
off credit, and try to collect on existing loans’.
• A collusive strategy of concealment of true
balance sheet position widespread in Japan.
• So the insolvency ‘black hole’ only detectable by
the gross distortion to investment spending!
Normal times – and hard times
• In normal times, insolvency is an economic
form of natural selection – .it’s the way the
capitalist system has evolved to shift resources
from less to more productive uses.
• In aftermath of bursting bubble, insolvency
may occur as a toxic by-product of debt
collateralisation – threatening to swallow whole
sectors of the economy and lead to gross
misallocation of resources.
• Unlike the space traveller sliding into the black
hole, however, firms can be rescued from this
kind of insolvency - as we discuss.
Iconic model to be used
• To illustrate the mechanism leading to mass
insolvency, we look at a model with Small
Business borrowers and Deep Pocket
lenders who demand collateral, that of
Kiyotaki and Moore (1997) published when
they were at London School of Economics
• Need to look at normal times …. and
abnormal times of bubble expansion followed
Normal times: a step-by-step expansion
of Small Business sector, SB
and User Cost
Normal times; and pleasant
• In normal times, as we have seen, small
businesses expand (or contract) smoothly
• An unexpected macroeconomic shock can have
a powerful ‘centrifugal’ effect. A temporary rise
in productivity, for example, will raise a firm’s
cash flow and increase borrowing power – and,
if the productivity shock affects all firms across
the sector, that will raise asset prices, further
increasing borrowing power.
Adjustment in ‘normal times’ (green line) and
after positive productivity shock (blue line)
Asset Price jump
What about abnormal times:
bubbles and bad shocks
• Consider first the system in a fevered state with
an asset bubble: firms borrow but that’s no
problem as asset prices keep rising to match the
• Then, unexpectedly, the music stops – the
• System may recover, or it may collapse.
Asset bubble and ‘black hole’
Small business asset holdings
The prospect of mass insolvency
• Need to look at the net worth of Small
Business sector and how it evolves:
• First in normal times, with no unexpected
macro shocks, but lots of small
idiosyncratic shocks at micro level that
cancel out on aggregate.
• Then, after a macro shock – a
synchronised shock, when all Small
Businesses might become insolvent
Evolving net worth of Small
Businesses in ‘normal times’…
Evolution of Small
Business net worth
… and after a bad shock
Help may be at hand
• Collusive concealment as in Japan:
CEO and bank manager hide the truth
• Asset purchase as in US Paulson Plan
• Capital Injection as in UK Treasury Plan
• Quantitative easing CB lends against
• All being well, these can stop the slide into
the Black Hole
Asset bubble and ‘black hole’
Help from Central Banks - since Aug ‘07
Plus support from Government
Jan. 2007 Latest
Guarantees of financial
Insurance of financial assets
Capital injections to banks and
special purpose vehicles
Increase in public sector support
(including CB assistance)
• Percentage of GDP
Financial Externalities exist in
economy with financial constraints
• Market economies with constraints that depend
on market prices (such as [email protected], collateral
requirements) are not constrained efficient.
• Rational atomistic agents take asset prices as
given and do not internalize the fact that their
fire-sale disposals give rise to amplification
effects when financing constraints are binding.
• Korinek (2009)
This leads to over-borrowing and
over investing by banks
• Value of liquidity in a crisis is undervalued
and this leads to distortoted decisions
• Bankers take on too much risk - over
borrow and over-invest
What if expectations are incorrect?
• Korinek goes on to point out that
• amplification effects magnify the impact of
any unexpected change to liquidity
• In crisis times when constraints are
binding, welfare costs of asset price
corrections are much larger than in normal
Moral: tax the HLI*s who generate
• Relaxing financial constraints (forbearance)
leads to Moral Hazard
• So does providing price guarantees
• So Korinek(2009) advocates Pigovian taxation
of externalities associated with HLIs – e.g. by
capital adequacy ratios and presumably
• *inc any player who might get involved in ‘fire-sales’,
banks, shadow banks and hedge funds.
The current challenge:
• “Academic economists analyse financial
regulations, what we must do is change
them” (with apologies to V. I Lenin)
• Will this crisis prompt the necessary
• What are the obstacles? Political
economy? Academic paradigm that denies
existence of crisis?
The economics of denial?
‘every financial system has a black hole: except RBC’
• US and UK banks are borrowing at low rates
and posting great profits and not lending much.
• So it seems that the solution being followed is to
fatten the fat cats so they won’t risk their wealth!
• Reminds one of pre FDR USA with big steel, big
oil and JP Morgan.
• Is that the future? Why not update the regulatory
structure that FDR created taking account of the
externalities and oioncentive issues.
• Earlier the world was warned that BASEL II was
not addressing the issue of systemic stability:
but BASEL II has been chosen.
• This time we face the choice again. Which path
will be taken.
• Robert Frost
• Two roads diverged in a wood, and I-• I took the one less traveled by,
• And that has made all the difference.
The Holy Grail of theoretical physics…
to unify gravity and quantum mechanics into a single theory!
What about economics?
• Some economists like to think of economics as a
science: and they seek to unify macro and micro
• Real Business Cycle theorists, for example,
assume a Representative Agent with Rational
Expectations: but RBC(RA & RE) no BH!
• So, as Krugman says, they may have mistaken
beauty for truth.
• Alas! One rejection is enough to discredit a
Two approaches to macroeconomics
Alternative: look to see how things really
function - and may fail
Current paradigm: the
postulate of perfection
The Economic Universe ?
‘every financial system has a black hole’ Fed economist
What are the alternatives?
• If one is to unify micro and macro, should
it not be along lines of Kiyotaki and Moore
with Heterogeneous Agents (Borrowers
and Lenders), and possibility of a Bubble?
Note that KM( noRA & noRE) BH.
• Personally, I think John Hicks was right to
say that economics is a discipline but not
a science: but that’s another story.
A sting in the tail
• From cosmological black holes there is no
escape: from financial black holes there is.
• Where the problem stems from the
existence of externalities and distorted
incentives in the economy itself, rescues
can increase moral hazard.
• Unless sufficient energy is dedicated to
countering the externalities and distorted
incentives, these rescues could increase
the probability of future crises.