About overborrowing

Two somewhat related papers this week.

Overborrowing and systemic externalities in the business cycle

by Javier Bianchi

http://d.repec.org/n?u=RePEc:fip:fedawp:2009-24&r=dge

Credit constraints that link a private agent’s debt to market-determined prices embody a credit externality that drives a wedge between competitive and constrained socially optimal equilibria, inducing private agents to overborrow. The externality arises because agents fail to internalize the debt-deflation effects of additional borrowing when negative income shocks trigger the credit constraint. We quantify the effects of this inefficiency in a two-sector dynamic stochastic general equilibrium model of a small open economy calibrated to emerging markets. The credit externality increases the probability of financial crises by a factor of seven and causes the maximum drop in consumption to increase by 10 percentage points.

Rising indebtedness and hyperbolic discounting: a welfare analysis

by Makoto Nakajima

http://d.repec.org/n?u=RePEc:fip:fedpwp:09-25&r=dge

Is the observed rapid increase in consumer debt over the last three decades good news for consumers? This paper quantitatively studies macroeconomic and welfare implications of relaxing borrowing constraints when consumers exhibit a hyperbolic discounting preference. In particular, the author constructs a calibrated general equilibrium life-cycle model with uninsured idiosyncratic earnings shocks and a quasi-hyperbolic discounting preference and examines the effect of relaxation of the borrowing constraint which generates increased indebtedness. The model can capture the two contrasting views associated with increased indebtedness: the positive view, which links increased indebtedness to financial sector development and better insurance, and the negative view, which associates increased indebtedness with consumers’ over-borrowing. He finds that while there is a welfare gain as large as 0.4 percent of flow consumption from a relaxed borrowing constraint, which is consistent with the observed increase in aggregate debt between 1980 and 2000 in the model with standard exponential discounting consumers, there is a welfare loss of 0.2 percent in the model with hyperbolic discounting consumers. This result holds in spite of the observational similarity of the two models; the macroeconomic implications of a relaxed borrowing constraint are similar between the two models. Cross-sectionally, although consumers of high and low productivity gain and medium productivity consumers suffer due to a relaxed borrowing constraint in both models, the welfare gain of low-productivity consumers is substantially reduced (and becomes negative in the case of strong hyperbolic discounting) in the hyperbolic discounting model due to the welfare loss from over-borrowing. Finally, the author finds that the optimal (social welfare maximizing) borrowing limit is 15 percent of average income, which is substantially lower than both the optimal level implied by the exponential discounting model (37 percent) and the level of the U.S. economy in 2000 implied by the model (29 percent).

The Bianchi paper shows that agents overborrow and this has negative consequences on the economy because of a larger risk of financial crises. The Nakajima paper argues that the observed increase in borrowing may be due to overborrowing due to hyperbolic discounting and financial innovation and the negative welfare effect of hyperbolic discounting dominates. Should one restrain consumer borrowing even if standard model indicate that completing markets should be welfare improving?

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2 Responses to About overborrowing

  1. M.H. says:

    Isn’t completing markets always good? Because if markets are incomplete, one can always insure against whatever bad could happen. So the problem is rather about trading off different kinds of incompleteness.

  2. First of all, I’d like to thank Christian Zimmermann for choosing my paper for this week.

    Regarding the issue on whether completing market is always good, in a model with incomplete markets, introducing new securities can make everybody worse off. This can’t happen for example if the new set of securities effectively complete the market. Since this issue is theoretically ambiguous, a quantitative approach is often needed. I believe the bottom line of these papers is that eventhough restricting borrowing is bad in a first best world, this may not be the case from a second-best standpoint.

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