The Mayekawa Lecture:
The Role of Default
in Macroeconomics
Charles A. E. Goodhart and Dimitrios P. Tsomocos

What is the main limitation of much modern macroeconomic theory,
among the failings pointed out by William R. White at the 2010 Mayekawa
Lecture? We argue that the main deficiency is a failure to incorporate thepossibility of default, including that of banks, into the core of the analysis.
With default assumed away, there can be no role for financial intermediaries, for financial disturbances, or even for money. Models incorporating
defaults are, however, harder to construct, in part because the representative agent fiction must be abandoned. Moreover, financial crises are hardto predict and to resolve. All of the previously available alternatives forhandling failing systemically important financial institutions (SIFIs) areproblematical. We end by discussing a variety of current proposals for
improving the resolution of failed SIFIs.
Keywords: Default; Transversality; Money; Bankruptcy cost; Assetbubbles; Resolution mechanisms
JEL Classification: B40, E12, E30, E40, E44, G18, G20, G28, P10

Charles A. E. Goodhart: Norman Sosnow Professor of Banking and Finance, London School of
Economics (E-mail: c.a.goodhart@lse.ac.uk)
Dimitrios P. Tsomocos: Saïd Business School, University of Oxford (E-mail: dimitrios.
tsomocos@sbs.ox.ac.uk)

MONETARY AND ECONOMIC STUDIES/NOVEMBER 2011
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I. Introduction
Last year, our friend and colleague, Bill White, with whom one of us has worked
now for more than 40 years, first at the Bank of England and subsequently, gave
the Mayekawa Lecture on the subject of “Some Alternative Perspectives on Macroeconomic Theory and Some Policy Implications” (White [2010]). The lecture this year
is complementary to that earlier lecture and tries to extend and to build on it. Bill
pointed out several of the main deficiencies of modern theory.
Let us quote from the opening section of his paper:[T]he prevailing macroeconomic frameworks simply allowed no room for crisesof the sort we are currently experiencing. . . . Absent an analytical frameworkthat included the possibility of crises and deep economic slumps, it is not surprising that the crisis was not commonly anticipated. Nor is it surprising that nopolicy efforts were made to prevent the crisis from happening.
Moreover, absent any fears of crisis, few ex ante preparations were madeto help improve crisis management (e.g., adequate deposit insurance, special
legislation for the insolvency of financial institutions, and so on). Further, ex
post crisis management was also inadequate in that each stage of the downturn
was treated as the last, and recovery was constantly said to be imminent. By way
of example, problems in the banking sector were initially treated as having to dowith liquidity rather than solvency, and it was generally assumed that traditional
Keynesian policy responses would suffice to restore full employment. . . .
It will be contended in this paper that the two workhorses of post-WorldWar II macroeconomics have serious practical deficiencies. These workhorses
are referred to here as modern macroeconomics (made up of the New Classicaland New Keynesian models favored by academics) and applied Keynesian models (generally empirically estimated IS/LM models of the type still favored bypolicymakers and other applied economists). The former models rule out crises
and deep slumps by assumption. The latter set of models underestimates thecontributions made to deep slumps by developments occurring in the upswing.
Thus, they overestimate the capacity of Keynesian policies to moderate deep
slumps when they do occur. In effect, they also rule out deep slumps, but on
the basis of the assumption that policy will always work effectively to moderatethem. Taken together, these points also imply a greater need to lean against the
upswings of credit cycles rather than to simply try to clean up afterward.
To remedy these deficiencies, it will be argued here that a new analyticalsynthesis is required. The building blocks of such a synthesis would be an increased focus on credit, stocks rather than flows (balance sheets), the possibilityof stock “imbalances” (in particular excessive levels of debt), and the process oftransition into crisis. In effect, the work of Keynes needs to be complemented byadditional insights from the Austrian School of Economics, and still others fromthe work of Hyman Minsky.

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The Mayekawa Lecture: The Role of Default in Macroeconomics

In our view, Bill White’s assessment of the defects of current macroeconomic theory
is pertinent, but we would not follow his approbation for Austrian theory, at least notin general. While we do agree with the praise for Hyman Minsky, we would note thatneither Hy Minsky nor Bill himself have appeared able to express their insights inthe form of a well-defined mathematical model. There were no equations, no algebra,
not even any charts or tables in Bill’s lecture last year. While this may have comeas a blessed relief to many of his listeners, and we shall follow his example in thisrespect, such a lack of formalization remains a considerable handicap to having one’s
ideas accepted by a profession that has pretensions to being a proper science, and gives
greater weight to mathematical precision than to empirical realism.
But above all, we do not think that Bill quite put his finger on what we see as thecentral, crucial deficiency of the standard forms, and mechanisms, of modern macro
theory. This is their failure to incorporate the concept of default, that is, that borrowersof credit may fail fully to repay what they had previously promised, to renege on theirdebt commitments, into their core models.
As soon becomes obvious, once one tries to include the potentiality for default
into a macro model, such modeling becomes much harder. Partly as a result, default isassumed away in the standard Walrasian models, from which the dynamic stochastic
general equilibrium (DSGE) model is directly descended. In the technical jargon, thetransversality condition implies that all debtors repay all their due debts in full by theterminal date of the model.
But this assumption requires two conditions to hold, both of which are patently
false. The first is that no debtor fails to repay, even when it is in his own self-interest
so to do (i.e., no strategic defaults); that is, that we are maximizing something beyond
our own utility. The second is that, whatever happens in the future, the debtor will
still be able to repay. This must logically require complete financial markets, wherein
all eventualities, including Donald Rumsfeld’s famous “unknown unknowns,” can behedged. How can you price and hedge the unknown? Since the number of potential
future outcomes is infinite, any transaction cost, however minute, would make the whole
exercise infeasible.
Nevertheless, Walrasian models, and their modern descendants, are based on thisfiction of perfect frictionless financial markets (plus debtors who place honest repayment above self-interest, a condition perhaps more nearly realized in Tokyo than in
London or Athens!). Apart from its obvious lack of realism, such perfect, frictionless financial markets have strong consequential implications for the structure of thefinancial system.
First, there is no need for financial intermediaries, whereby firms interpose theirown credit standing or credit analysis between the ultimate saver and ultimate borrower,
since there is no credit risk. All borrowers—whether the government or a noodle-shop
owner, Governor Shirakawa, or yourself—are known with certainty to have no credit
risk at all. All can borrow, or lend, in a frictionless world without transaction cost at therisk-less interest rate. So there is no room in such a world for banks or money market
mutual funds. Moreover, in such a perfect financial system where the probability of
all future eventualities is assumed to be known, and can be hedged without transaction
cost, there would seem to be no room for specialist insurance companies or pension

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funds. The complete perfect market will do it all. Our core models assume away thewhole structure of financial intermediation. As Bill White correctly emphasized, this is
not the mark of an evidence-based science.
Indeed, in Michael Woodford’s iconic book, Interest and Prices (Woodford [2003]),
this implication is accepted and financial intermediaries play no role at all. However,whereas standard macro modelers have been willing to embrace the logic of their assumptions in respect of the absence of any role for financial intermediation (at best, aveil), they gag at the further but equally logical step of eliminating money—and hence
inflation—from their models, perhaps because such models have a nominal interest rate,a Taylor reaction function and inflation (expectations) as key working parts.
It has long been known at the theoretical level that Walrasian (Arrow, Debreu,
Hahn) models with perfect and complete financial markets have no logical role formoney. When everyone is risk-less, then anyone’s IOU can and would be immediately
and fully acceptable in payment for goods or services. There would still be a need for an
accounting system (the divine accountant marking to a perfect market) and possibly fora numeraire, but not for a special asset category called money. Why need anyone hold“money,” when his or her own IOU is entirely acceptable in any exchange? To include“money” in a system with perfect financial markets in someone’s utility function is justa logical error. It is, indeed, the concept of default—that not all debts are fully repaid—
which gives substance and meaning to the human instruments of money, liquidity,banks, and the whole panoply of finance.
If there ever could be such a frictionless, perfect financial system, could we still givemeaning to the rate of interest? Yes, of course, but it would be a real rate, affected by realfactors such as time preference, the marginal efficiency of investment, and so on. Could
the government then influence it, if other frictions, such as wage and price stickiness,or other shocks such as war or national disasters strike, causing unemployment?
The answer is yes. By its powers of taxation, the government can reduce the private
sector’s current access to consumption, and by increasing its expenditures, it could raisepresent consumption relative to the future. So the government can vary the trade-off
between present and future goods. Of course, if there were no such frictions (or shocks),
the private sector, assuming also that the government never defaults, could and would
offset the government’s actions (as Barro [1974] showed long ago). But so long as there
are real frictions, there can be a fiscal theory of (real) interest rates.1
Without a clear appreciation of the essential nexus between default and money (orliquidity), monetary theory tends to get into a mess. This, for example, is exemplified
by the attempt to base theories of the evolution, and role, for money on the need tominimize transaction costs in markets. But the appropriate counterfactual, at least formost purposes, to a monetary economy is not a barter economy, but a pure credit economy. Moreover, money—and credit—developed over time not so much in the context
of markets for goods and services, but in the context of social inter-relationships. But
one of us has already written on this subject at some length in his paper on “The Two

1. There can also be real automatic stabilizers. In Egypt, which had not invented money, taxation was related tothe height of the Nile flood. The higher the flood, the better the harvest. So the tax level for the year, payable ingrain or labor, was adjusted according to the flood gauge.

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The Mayekawa Lecture: The Role of Default in Macroeconomics

Concepts of Money” (Goodhart [1998]). And today’s paper is to focus on default, rather
than money.
So, in Section II, we shall discuss ways to model default. It has been, we would
suggest, the inherent difficulty of doing so that has led most economists to assume
it away. Then, in Section III, we shall move on to outline various ways of trying toforecast an economy in which systemic financial failure is a possibility, though perhaps(hopefully) only as a tail risk. In the final section (Section IV), we shall consider avariety of methods for handling, and minimizing the cost of, financial failure (especiallyof banking failure).

II. Including Default in Macroeconomic Models
Default is hard to model formally, partly because it is a discontinuous variable. A company (or other economic agent) is either in default of a commitment, or not. So, prior
to Martin Shubik’s original work (Shubik and Wilson [1977]), there was relatively little
attempt to include default in formal macroeconomic models, although the probabilityof default has always played a central role in finance.
Shubik described money as an “institutionalized symbol of trust,” and Kiyotaki andMoore (2002) coined a nice phrase, “Evil is the root of all money.” And they are correct
in this. If everyone always repaid all their debts with certainty, all that would be needed
to complete a transaction would be a handshake and the acknowledgment that the buyer
is indebted to the seller. Of course, the good that the seller would like to receive at somefuture date would not necessarily be what the buyer could offer, but this discrepancy
could easily be resolved in complete financial markets.
It is, indeed, the possibility of default on contractual obligations that implies the necessity for the cash-in-advance constraints that we employ in our model. The interplayof liquidity and default justifies fiat money, based on the (tax) powers of government,
as the stipulated mean of exchange. Otherwise, the mere presence of a monetary sector
without the possibility of endogenous default or any other friction in equilibrium will
become a veil without affecting real trade and, eventually, final equilibrium allocations.
The closest precursor to our present suite of models is the work of Shapley andShubik (1977) and Shubik (1973, 1999), who introduced a central bank with exogenously specified stocks of money and cash-in-advance constraints in a strategic market game. The commercial banking sector of our models follows closely Shubik and
Tsomocos (1992), who used, however, gold-backed money and modeled a mutual bankwith fractional reserves. Finally, the modeling of money and default in an incomplete
markets framework is akin to the models developed by Dubey and Geanakoplos (1992)
and Dubey, Geanakoplos, and Shubik (2005). However, Dubey and Geanakoplos (1992,
2003) is a one-period model with money and default, Dubey and Geanakoplos (2003)
include incomplete asset markets and money, and Dubey, Geanakoplos, and Shubik(2005) have incomplete asset markets, default, and no money. None of the previous
papers combined all these three ingredients, incorporates a competitive commercial
banking sector, and focuses on financial fragility. However, Goodhart, Sunirand, andTsomocos (2006a) and Tsomocos (2003a, b) combine all three characteristics. Default

53

is modeled as in Shubik (1973) and Shubik and Wilson (1977), namely, by subtracting a linear term from the objective function of the defaulter proportional to thedebt outstanding.
In these papers, Shubik developed a method whereby default can be incorporated
into formal models. It runs as follows: the advantage of default is that it enables theborrower not to repay all that he owes. The disadvantage is that society imposes certain
costs on defaulters, whether pecuniary (lawyers’ fees, no access to further borrowing, etc.) or non-pecuniary (reputational damage, debtors’ jail, etc.). If the costs ofbankruptcy are zero, everyone would default totally and no one would lend. If the costwere infinite, no one would borrow. So there must be an interior optimum at which
the benefits of default just balance its costs. The actual incidence of default then for
any agent depends on the interaction of the agent’s preferred strategy interacting withthe state of the economy, so that when output is low and consumption temporarily
depressed, the marginal utility of extra consumption (from default) reduces the share of
the debts that the debtor will pay back, the repayment rate. In other words, default (theinverse of the repayment rate) is always and simultaneously both strategic, dependent
on each agent’s character, and endogenous, dependent on the state of the world.
An implication of this approach is that the mean expected default rate for all agents,
however low, remains non-zero in almost all states of the world. The expected, and ex
post actual, repayment rate is rarely 100 percent. Of course, in cases where bankruptcy
costs are high, economic conditions are good, and the agent is both risk averse andhonorable, the repayment rate may rise close to 100 percent. In reverse circumstances,
the repayment rate may fall sharply.
Formally, this relationship can be described as a constrained maximization problem; and the specification of default can include the idea (first introduced by Shubik
and Wilson [1977]) that utility decreases monotonically in the level of default because it
becomes more expensive to default. In equilibrium, agents equalize the marginal utilityof defaulting (i.e., increased consumption) with the marginal disutility of the bankruptcy
penalty. Then, under rational expectations, expected rates of delivery of repayments ofall kinds of debt in all periods and states of nature are equal to actual rates of delivery inequilibrium. This concept is the crucial ingredient of the model, since it allows default
as an equilibrium outcome without necessarily collapsing the orderly functioning of thefinancial system.
There are some who find the concept of a partial repayment rate objectionable,
because agents either default, or not (a binary division). But in a sector consisting ofmany small individual units—for example, companies or households—one can thinkof the average repayment rate of the sector as a whole. And where the sector consists of one, or a few, agents—for example, government, oligopolistic banks or carcompanies—even when the agent defaults, most creditors get some partial repayment.
Thus, the bondholders with claims on Argentina or the Irish banks usually get somepartial repayment.
So the Shubik approach, with its assessment of ex ante expected, and its post actual,
repayment rates is, we claim, realistic. Alternatively, we can model default on collateralized loans. In the initial period, agents finance their investment through collateralizedborrowing. When they borrow from the collateralized loan markets, they pledge the54 MONETARY AND ECONOMIC STUDIES/NOVEMBER 2011

The Mayekawa Lecture: The Role of Default in Macroeconomics

assets purchased as collateral. In the second period, the borrowers either deliver in full
the amount of the collateralized loan, or default. In the case of default, the collateralpledged is foreclosed and is put up for sale in the secondary capital market. The receipts
are transferred to the banks and determine the effective return on the collateralized loan.
More involved collateral requirements can be introduced. Due to our general equilibrium framework, every contract is priced in equilibrium. When equilibrium prices are
such that the value of the collateral is higher than the nominal value of the loan, theagent will repay fully. When equilibrium prices are such that the value of the collateralin the future is less than the amount the agent must repay, he would rather default,
purchase, for instance, the same amount of capital from the secondary market, andbe better off. Default is an endogenous decision stemming from utility optimization.
This process of default, and subsequent fire sale of assets can then generate the debt
deflation channel whereby monetary policy and money supply matter for the determination of asset prices, such as the interest rate on the collateralized loan, and theyaffect the decision to default and the level of aggregate output (see Lin, Tsomocos, andVardoulakis [2010]).
The other main problem that this approach engenders is that of dimensionality. At
the very least models of this kind involve, as an essential component, an additionalbanking sector. If one is concerned with interactions, within the banking sector for
example, then the requisite number of agents in the model rises much faster. Moreover, unless all the agents have prior knowledge of the long-run equilibrium propertiesof the system, which seems implausible, the progress of the system will be path dependent. Thus, we show in Bhattacharya et al. (2011) that financial collapses will be
more extreme after a sequence of good outcomes, since agents will have revised their
expectations in such a way as to assume more risk.
The opposite side of the coin, however, is that we can make models of this kindquite feasible to explore whichever problem is at hand. Thus, we can use this approachto develop a DSGE model in which the only friction is financial, or in which there areboth wage/price and financial frictions. The initial endeavors, by Curdia and Woodford(2009), Leao and Leao (2007), de Walque, Pierrard, and Rouabah (2010), and Iacovielloand Neri (2010), which introduced some aspects of financial friction into the DSGE
framework, have not taken into account simultaneously liquidity, agent heterogeneity,money, and default risk. The majority of these models attempt to model default as an
out-of-equilibrium phenomenon that never occurs in equilibrium. Nevertheless, thesemodels are valuable efforts toward a plausible explanation of the phenomena observed
during and after the credit crisis. One paper that attempts to achieve this synthesis is
Martinez and Tsomocos (2011).
One of the crucial elements remaining to be introduced into the DSGE frameworkis the liquidity constraint the agents face, because goods are not fully readily tradable
for other goods. Acharya and Pedersen (2005), Acharya, Shin, and Yorulmazer (2011)
and Acharya and Viswanathan (2011), Brunnermeier and Pedersen (2009), and Vayanos(2004) have all studied liquidity within partial equilibrium models. In our models, liquidity will be modeled following Espinoza and Tsomocos (2008). Such an extension
to the dynamic framework will be a direct and useful tool to assess the impact of thefinancial and real shocks, since it has two important advantages. The first is the ability55

to monitor the impact of a liquidity shock in the short, but also medium, run. The second
is that the dynamic setting allows us to parameterize different liquidity environments(i.e., steady-state values) and examine how shocks impact the economic variables ineach case.
Perhaps the main purpose of our program of work has been to develop models
that might be used to explore financial stability. Thus, our earlier models focused oninteractions within the banking sector. In particular, Goodhart, Sunirand, and Tsomocos(2006b) and Tsomocos (2003a, b) set out a tractable model that illuminates problems
relating to individual bank behavior, to possible contagious inter-relationships between
banks, and to the appropriate design of prudential requirements and incentives to limit“excessive” risk-taking. Our model is rich enough to include heterogeneous agents,
endogenous default, and multiple commodity, and credit and deposit markets. Yet it
is simple enough to be effectively computable and can therefore be used as a practical framework to analyze financial fragility. Financial fragility in our model emerges
naturally as an equilibrium phenomenon. Among other results, a nontrivial quantity
theory of money is derived, liquidity and default premia co-determine interest rates,and both regulatory and monetary policies have nonneutral effects. The model also
indicates how monetary policy may affect financial fragility, thus highlighting the tradeoff between financial stability and economic efficiency. Other papers, using this—or aclosely similar—model, mostly developed within central banks, include Saade, Osorio,
and Estrada (2007) and Goodhart, Sunirand, and Tsomocos (2006b).
Given the importance of the boom/bust cycle in the property market, both residential and commercial, we have developed models to explore and to simulate suchcrises. Goodhart, Tsomocos, and Vardoulakis (2010) build on our previous model of asystem in which default plays a central role for both borrowers and banks, and in which
financial intermediation and money, therefore, have a necessary real function, to include
both an additional good—housing—in addition to the prior composite basket of othergoods and services, and an additional agent—a new entrant to the housing market. So
our model is general enough to allow for the examination of a wide variety of shocks,
which can lead to financial instability.

III. Default and Forecasting
A. Extrapolating the Past
Our past history is all that we (partially)2 know. From this we can extract trends, forexample, of output, productivity, monetary growth, velocity, inflation, and so on. Givensuch trends, the actual time series exhibit cycles, of varying periodicity, around thetrend. One of the strongest maintained assumptions in economics is that the system has
an equilibrium (rate of growth), to which the economy would revert in the longer run, in
the absence of future shocks (including defaults and financial shocks). DSGE models

2. The downgrading of the teaching of economic history from its prior role as part of the core curriculum of an
economics degree to a lesser status as an inessential specialization has meant that most economists know evenless of their past history than previously.

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The Mayekawa Lecture: The Role of Default in Macroeconomics

Figure 1 Stylized Pattern of Relationships between Forecasts and Out-Turns of Macro
Variables over the Cycle

are in general constructed around a strong assumption of reversion to an equilibrium(Brunnermeier and Sannikov [2011]).
At any time, however, the economic system is out of equilibrium, and is at somestage of a cycle, with its own autoregressive momentum. Thus, stripped of its detail,most economic forecasting represents a balance between the centrifugal forces of ongoing cyclical momentum and the centripetal forces of reversion to the long-run equilibrium. In practice, most forecasters are poor at predicting cyclical turning points.
Hence they tend to predict some fairly constant combination of autoregressive momentum and reversion to the mean. As a result, so long as the up phase of a cycle continues,
forecasters tend to underestimate outcomes, and vice versa in the down phase. This
gives rise to a common pattern of outcomes and predictions looking like Figure 1; see
Goodhart and Lim (2011).
While many of the shocks giving rise to this pattern are real—for example, technology, productivity, and supply shocks—some are financial. The most serious financial
shocks are those that occur after periods of strong and stable growth, with increasing
optimism about declining volatility and lower risks. Explanations of this syndromeare given by Minsky (e.g., Minsky [1982, 1992]) and modeled by Bhattacharya et al.
(2011). Examples are the United States (1929), Japan (1990), Southeast Asia (1997),
and the developed economies (2007–08). After such a financial shock, there is generally a longish period of stagnant credit expansion and slow growth (Reinhart andRogoff [2009]).
The financial crisis leads to a regulatory response, to tighten up, and more government intervention in the operation of the financial system. Some, for example,
Congdon (2009, 2010, 2011), argue that such intervention and tightened regulatory57requirements are themselves a cause of the resultant slower growth of money, credit,
and output. Be that as it may, the new and reinforced regulatory controls, following
the Great Depression of 1929–33, then ushered in a long period from the 1930s to the
1960s that was characterized by constrained, repressed banking, but which was free ofbanking/financial crises.
Although the crises in the early 1970s were in some countries associated with financial liberalization—for example, the United Kingdom—the main blame was placedon poor government policies (e.g., incomes policies) and (oil) supply shocks. So despite a number of other episodes of financial stress (the less-developed-country crisisof 1981–82, involving Mexico, Argentina, and Brazil; the housing/European exchange
rate mechanism [ERM] crisis of 1991–92; and the Southeast Asian/Long-Term CapitalManagement crisis of 1997–98), the process whereby further and extended financial
liberalization and globalization coincided with increasing official success in achieving
low and stable inflation and steady growth, the “Great Moderation,” continued until
punctuated by the financial crisis of 2007–08.
If one calls this period from the 1929 crisis until the 2008 crisis a single super-cycle,
then we have really only had one such episode. This is far too small to extrapolate into
the future. But perhaps the example of Japan, whose own idiosyncratic crisis occurredmuch earlier in the 1990s, gives a warning that developed economies more generally
may now be prone to a period of much slower growth both of the monetary aggregatesand of output. How far such slower growth in money and credit is responsible for, andhow far it is simply caused by, the slower growth in demand and output is not easy
to discern.
The adoption of unconventional monetary policy measures—notably, quantitativeeasing (QE)—has been an attempt to reinvigorate monetary expansion. Insofar as thiswas expected to run via injections of base money, through the traditional money multiplier to the broader monetary aggregates, it was, however, a dramatic example of theeffect of Goodhart’s law. Insofar, however, as it was expected to run via enhanced
liquidity (and money balances) into asset prices more generally and into a recoveryof certain dysfunctional financial markets, it has been quite successful, though exactly
how successful remains a contentious and contested subject.
Clearly the virulence of the current boom/bust cycle, both in Japan and more
recently in developed economies, owes much to the interaction of the housing andfinancial cycles. Standard DSGE models incorporate neither sector. We have tried toincorporate both, notably in our 2010 paper with Vardoulakis, already cited. Be that as
it may, a policy response that focuses almost entirely on the monetary side and fails todeal with the continuing downward pressures on housing and land prices, for example,
from foreclosures, is likely to be lopsided and only partially effective. Surely it is difficult to design a satisfactory policy to cope with mortgage default and consequential
foreclosures, but the failure to do so has been a millstone holding down recovery in the
United States and Japan. Looking again at the set of policies for housing, including
importantly the bankruptcy provisions and “skin in the game” loan-to-value (LTV)
requirements, remains a key element of unfinished business.
Equally the nexus between additional financial regulation and the pace of monetaryand credit expansion remains a highly contentious issue. Many economists (Admati

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et al. [2011], Miles, Yang, and Marcheggiano [2011], and Barrell et al. [2010]) andregulators (Basel Committee on Banking Supervision [2010a, b]) believe that tougher
capital and liquidity requirements, so long as these are introduced quite gradually, will
only have minor effects on interest rate spreads, and hence on credit and monetary
aggregates. A few economists (Congdon again) and many in the industry contest this(Institute of International Finance [2010]) claiming that the effect already has been, is,and will be significant and damaging to recovery.
In our view, a crucial issue is the way that such tougher requirements are introduced. If banks are given a target for the absolute value of core tier 1 equity, based on
their current total value of assets/liabilities, to prevent them from achieving a required
ratio by delevering further, and if that target value of capital is enforced by dividend
restrictions—and maybe bonus restrictions—until it is reached, then it could be met
without adverse effects on the real economy. The continued proclivity of banks to pay
out dividends and bonuses after the crisis struck in August 2007 and the prematurerelaxation on U.S. dividend payments in March 2011 should not have been allowed tooccur. On this, see Acharya et al. and Goodhart et al. (2010).
Nevertheless, what is clear is that now that we in developed economies have entered
the post-crisis (bust) stage, we still do not have much ability to forecast how the financial
sector will respond to tougher regulation, and/or how developments in the financial
sector will influence the real economy. We simply do not have the models to do so. Of
course, a few diehard adherents of the previously mainstream DSGE models, without
housing or finance sectors, may claim that none of this matters, that the only shocks are
real, but it is hard to take such protestations seriously.
But policymakers, and most outside commentators, are not so much concerned with
forecasting in the depressed, recovery stage (though they should be, since that is where
we are now), as with the more high-colored (sexier) question of whether economists
can provide an “early warning system” (EWS) to predict, and so perhaps to forestall,
the advent of both systemic crises and of idiosyncratic individual bank failures. It is tothis that we now turn.
B. Can Crises Be Forecast?
The first international banking problems since the interwar period surfaced in 1974
(Herstatt, Franklin National Bank, and fears about the recycling of petrodollars). Immediately thereafter, the Group of Ten (G10) central bank governors at the Bank ofInternational Settlements (BIS) meetings and finance ministers called for an EWS toanticipate such crises in the future. Indeed, it was largely for the purpose of providing
such an EWS that the Basel Committee on Banking Supervision (BCBS) was set up
initially in 1974–75 (Goodhart [2011]). Fortunately, since attempts to estimate such
an EWS have been of strictly limited success throughout, the BCBS soon turned its
attention instead to the somewhat more amenable subject of international, cross-border,bank regulation and supervision.
It is not perhaps surprising that the Lehman failure caught everyone by surprise.
After the handling of Bear Stearns and of Fannie Mae and Freddie Mac, by the Federal
Reserve and the Treasury, the general assumption had been that these authorities wouldfind some way to keep Lehman Brothers, and the other broker/dealer investment houses,59

in continuing operation. Indeed, it was partly the shock to such prior expectations, andthe resultant uncertainty about how the U.S. authorities might act from then on, thatcaused the crisis to become so sharp and abrupt (see Taylor [2009]).
Nevertheless, there are intrinsic reasons to doubt whether a really successful EWS
can ever be developed. As implied by the Lucas critique (and Goodhart’s law), if sucha warning system ever appeared to have predictive power, then agents’ behavior wouldchange, and the crisis would be averted, one way or another. The best that we canhope to achieve is a greater appreciation of the conditions of stress that may fostera crisis. Several of these are known already. They include credit expansion, leverage,
housing and property price inflation, and output growth, which are both rapid and above
trend. The crisis will also probably be worse when it is preceded by a current accountdeficit (Barrell et al. [2010] and Reinhart and Rogoff [2009]). There is also evidence
that periods in which the risk of a collapse (recovery)—as assessed by tail risk in asset
returns—is seen as higher than the opposite, but asset prices continue rising, herald a
sharp reversal (Cascon, Shadwick, and Shadwick [2011]).
As is fairly obvious, almost all the signs of potential stress are equivalently signsof an asset price boom. In a boom, almost everyone is making money and is optimistic.
Only the Cassandras and the doomsayers will have lost money. The precept of “buy on
the dips” will have led to fortune. Nobody can ever regularly predict either a turning
point or a change in trend. In this respect, macroeconomics has something in common
with seismology. There are always many who predict a continuing faster expansion:“it is different this time,” “the end of boom and bust,” “Dow 40,000,” and so on. Indeed, during the course of such a boom, the most accurate forecasters will be those
who have been generally most optimistic. It is difficult not to get caught up in the general enthusiasm; indeed as Frankel and Froot (1986, 1987) showed, the boom (bust)
only collapses once all the uncertain investors have finally jumped on the bandwagon.
Asset price booms and busts are market phenomena. The market itself by definition
cannot, and does not, predict its own crisis and reversal. Credit default swap (CDS)
spreads were never lower, and bank equity prices never much higher, than in June 2007.
Within a cyclical phase the market can predict quite well which company/bank will do
best/worst, but the market gives little or no guidance about future macro-developments,
or of its own sharp reversals.
Even if central bankers should manage to maintain their scepticism about asset
price bubbles (“irrational exuberance”), they would face intense (political) opposition
if they were to try to take measures to counter such a boom. “Taking away the punchbowl just when the party gets going” will not endear one to the guests. Given all theother difficulties of using countercyclical measures to halt an asset price boom, leaving
this just to the discretion of central banks is likely to result in them being underused.
We have, however, made this point in other papers.
Besides the repeated call, never effectively answered or answerable, for an EWS,
the other persistent nostrum of regulators seeking to forestall crisis is for stress tests.
These also are of very limited use. We are confident that had regulators applied a stresstest in June 2007 on the assumption of a decline in U.S. housing prices by June 2009of 20 percent (five times the maximum expected by econometric exercises and which
would then have been dismissed as totally implausible), not a single U.S. or European

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The Mayekawa Lecture: The Role of Default in Macroeconomics

bank would have appeared in any serious danger. Recall how the Irish banks passed theEuropean stress tests.
There are several inherent problems with stress tests. The first is that the regulators may be unwilling even to contemplate the most serious risk events, for instance,
the default of a sovereign debtor. A second is that the regulators running the stresstest need to have a convincing backstop policy in place to restore any bank, or otherfinancial intermediary, to reasonable health should it fail the test before the stresstest is applied. Otherwise, there would be growing doubts whether either a bank (orother financial institution) or the regulators themselves would be prepared to announce
such a test failure. Such a backstop (provided by the Troubled Asset Relief Program[TARP]) was in place in the successful U.S. stress test, but not in the unsuccessful
European test.
But the most important deficiency of any stress test is that it explores the effectof some exogenous, macroeconomic shock on an individual bank. It does not, andin practice cannot, examine the endogenous risk to the system as a whole, as banks
themselves react to the worsened situation by delevering, restricting (interbank) loans,requiring more collateral from counterparties, selling assets, and hoarding liquidity.
There are multiple sets of self-reinforcing spiral effects that drive financial bubbles
and busts (Brunnermeier et al. [2009]), and stress tests on individual banks will notreveal these.
This is not to suggest that such stress tests are a waste of time. They may be able toindicate comparative weakness, that is, which banks would be seen as most at risk fromsome exogenous event. But they are not of much value as a guide to the probability ofa systemic crisis. It is our view that the individual bank stress tests need to be complemented by top-down, model-based simulations of the banking (financial) system as awhole. One of the purposes of our work in building models in which banks and default
play a central role is precisely to provide a basis for carrying out such simulations. We
would not expect such models to be able to predict—to forecast—the actual occasion
and initial cause of the crisis itself, any more than any other (reduced-form) EWS, butthey might be able to estimate both the fragility of the system to such a crisis, forexample, as risk-aversion coefficients could be assumed to alter and also perhaps tochart the likely further direction of the crisis once it was underway.
This latter consideration leads to the question of how to assess the likely interactionof the financial system with the real economy, once a financial crisis has begun.
C. Forecasting Procedures after the Crisis Has Begun
A cyclical downturn that has been triggered by a financial crisis is likely to differ, inseveral respects, from a downturn caused by other factors, for example, official action tocounter inflation (Reinhart and Rogoff [2009, 2011] and Reinhart [2011]). The supplyof credit to marginal borrowers at least, and monetary growth, will be cut back. Spreads
between such government debt as is perceived to remain riskless and on riskier assets
are likely to widen.
Indeed, the simplest and most straightforward way to incorporate financial difficulties into a forecast for the real economy is just to substitute a risk-spread adjusted interest rate, in place of the official rate, into the model’s domestic expenditure function(s),61and then proceed as before. This is in effect the proposal of Curdia and Woodford(2009), and it has much to recommend it (also see Gilchrist and Zakrajsek [2011]).
There are, as always, problems. Exactly which risk spread should be used? Is theeffect on expenditures of a rise in official rates of 1 percent more or less equal to arise in the risk spread of 1 percent (official rates remaining constant)? We can thinkof arguments why the effect of the latter (risk spread rise) might be greater (additional
non-price rationing of credit) or less (not so pervasive; less effect on confidence andexpectations perhaps) than a rise in the official rate. We are not currently aware of any
conclusive econometric tests on this issue.
But the main problem with this approach is that the risk spread is treated as an exogenous variable, rather than being derived endogenously from the optimizing behaviorof agents. Moreover, the forecast will have to contain some estimate of the future pathof the risk spread itself. Of course, this too can be provided by some auxiliary model.
It could be univariate; thus, after an (unforeseeable) shock, risk spreads tend to revert
asymptotically to the low, long-run equilibrium, unless distorted by some further shock.
Or one could run a reduced-form equation, relating the spread to factors such as failure
rates, expected bank profitability and capital ratios, the increase in base money, and soon. Some might ask why not relate risk spreads to market variables such as option and
CDS prices; but such market pricing variables are in a sense just another facet of thesame market factor.
Ideally, we would like to be able to forecast risk spreads as one of the outputs of ourmore general equilibrium financial model, in which default plays a central role. But for
the time being, this is beyond our capabilities. Nevertheless, this can only be achieved
within a model of liquidity and endogenous default whereby spreads emerge in equilibrium and, hence, can be calibrated and used for policy determination and regulatory
purposes. At the same time, financial stability measures should be constructed that canbe easily implemented and used contemporaneously with inflation targeting to assessmonetary and financial stability policy.

IV. How to Handle the Default of a Global SIFIFew events have more destructive power than the default of a global systemicallyimportant financial institution (G-SIFI), especially if badly handled, as in the case of
the failure of Lehman Brothers. Not only is there a major loss of value, following theevent of default, to creditors and/or taxpayers, but much more important, the blow to
confidence and the subsequent effect on market prices can have an impact on the real
economy that is a large multiple of the direct loss from the initial failure. The failuresof Lehman Brothers, of Credit-Anstalt, and of the Knickerbocker Trust Company in1907 are examples. The extension of credit, and the working of the financial system,
are based in some large part on trust and confidence, and—should that trust suddenly
evaporate—the inner fragility of the capitalist system is revealed. This can be terrifying.
And for the creditors of the failing bank, the occasion of bankruptcy will tend of
itself to destroy value. We understand (from personal conversation) that, at the weekend
which settled the fate of Lehman Brothers, the assessed shortfall of value, once equity

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The Mayekawa Lecture: The Role of Default in Macroeconomics

had been wiped out, was somewhere in the region of US$25 billion. But after the bankruptcy had occurred, the eventual shortfall was around three times as large (or more).
What makes default such an expensive exercise? First, the generalized shock of theevent and the expectation of forced fire sales will cause the value of the assets held by
the bank to decline; with no ongoing reputational ties to maintain, debtors to the bankwill seek ways to delay or to diminish their repaying commitments; the specialized
personal knowledge of the bank employees suddenly loses value (goodwill disappears),
and the bankruptcy procedure itself is extremely expensive and time consuming.
So creditors of SIFIs, especially bondholders, often would have a common interestin providing more equity capital up front to rescue the failing SIFI rather than allow it
to default. There is, however, a major coordination problem to overcome in arranging
this. It is the purpose of contingent convertible (CoCo) bonds and of bail-in proceduresfor bondholders to try to overcome this coordination problem. But this is to run aheadof the currently unfolding story, since neither CoCos nor bail-in arrangements are yetin general widespread use.
Instead at present, when faced with the default of a bank or SIFI, the authorities
have only had three alternatives:(1) Try to arrange a merger with a stronger financial institution, sometimes sweetened by some (overt or covert) subsidy.
(2) Rescue the bank using taxpayers’ money.
(3) Allow it to go bankrupt and be liquidated.
All these alternatives have major disadvantages. The encouraged merger route increases concentration, reduces competition, may involve the outlay of taxpayers’ moneys (and/or can involve risky central bank loans), and may create a much larger weakbank, where formerly the absorbing bank was much healthier. The encouraged mergers
of Bear Stearns (into JPMorgan Chase), HBOS (into Lloyds TSB), and Merrill Lynch(into Bank of America) each illustrate some of these disadvantages. Nevertheless, inthe throes of a crisis this is often the preferred solution for the authorities.
When this solution became unavailable, the choice lies between propping up thefailing bank with taxpayers’ money or liquidating it. The experience of the failureof Lehman Brothers was so appalling that most governments thereafter decided thatliquidation of an SIFI could not be tolerated. So they moved rapidly to the use of taxpayers’ moneys to recapitalize failing banks. The problem with this was that it hasoften turned out to be too expensive for the public sector to sustain, “too big to save”
as in Ireland, and the political consequences of imposing austerity on taxpayers andpublic-sector employees to save banks and bankers—who are perceived to have behaved badly—have become insupportable. So this route has, in many respects, alsoreached its limits.
Since none of the current alternatives for handling failing SIFIs are acceptable, orare capable of much further utilization, the search is on for other methods for handling their default. We shall discuss three here; though they are separable, they are notnecessarily mutually exclusive:(1) Improve the liquidation process.
(2) Make the bondholder liable, via CoCos and bail-ins.
(3) Reform Prompt Corrective Action (PCA).

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The first alternative, as largely adopted in the Dodd-Frank Act, involves fourmain elements.
(a) Enactment of a Special Resolution Regime enabling the authorities to take overand manage the running of a bank prior to actual bankruptcy, to split it into a
good bank/bad bank, and so on, as soon as its supervisors come to the view thatits normal operations are no longer sustainable. This can be well before it isformally bankrupt.
(b) The requirement for all SIFIs that they complete “living wills” to the satisfactionof their supervisors. This should include both a crisis recovery component anda funeral plan, should the recovery fail (Huertas [2010a, b]). The funeral planshould enable the authorities to have the capacity to know in advance how toclose down this SIFI expeditiously and efficiently.
(c) An orderly liquidation process, ready to be put in place.
(d) A fund, to be provided ex ante, or ex post, by the remaining banks to meet theresidual cost of the liquidation.
Much of this program, especially (a) and (b), is admirable, but we doubt whether itwill work effectively for the following reasons. On (a), assessing when a bank has gotten
into an unsustainable state is extremely difficult, and will be contested by the bank’sowners and equity holders. Given the threat of a lawsuit, if such closure is to be left tothe discretion of the supervisors, it will come too late. On (b), the procedure for completing and updating “living wills” is, we expect, likely to be so time-consuming andexpensive for both the regulator and the regulated that it will be done only occasionallyand less thoroughly and completely than would in principle be ideal. On (c), the main
problem is that G-SIFIs are by definition cross-border (indeed most SIFIs are), and theinstitutional structure for organizing an orderly cross-border liquidation is nonexistent(Avgouleas, Goodhart, and Schoenmaker [2010], Goodhart and Schoenmaker [2009],
and Claessens, Herring, and Schoenmaker [2010]). Much of the disaster attending theLehman failure arose not from the treatment of the U.S. part of the firm, but from thechaos that occurred with the liquidation of Lehman Brothers (Europe) in London andLehman Brothers (Asia) in Tokyo. On (d), no one knows the correct premium (tax rate)
to charge ex ante, and the banks will fight the proposal. On the other hand, charging thebetter-run banks, which did not fail, ex post just when the banking system as a wholeis much weaker would be misguided (though this is proposed by Dodd-Frank!). For
additional criticisms of the Dodd-Frank Act, see Acharya et al. (2010). This is not to
say that such a process of orderly liquidation cannot work, nor that answers to theseobjections cannot be attempted; rather, the claim made here is that the concept of an“orderly” liquidation process remains highly problematical.
In contrast to the Americans, the Europeans now appear much keener on option (2),making the bondholder pay, whereas the Americans seem somewhat more sceptical.
There are two versions, CoCos and bail-ins. With the CoCo, a bond is issued that automatically transforms into equity when a preordained trigger is met, with a conversion
factor that is also settled in advance. The optimal form of both settings is quite complex
to decide. In our view, the best approach would be a market price of equity (maintained
over some 20 working days to avoid flash crash and sudden manipulation problems)that was quite high above the failure level and converted at a rate which diluted existing64 MONETARY AND ECONOMIC STUDIES/NOVEMBER 2011

The Mayekawa Lecture: The Role of Default in Macroeconomics

equity sufficiently to encourage existing equity holders to recapitalize themselves via a
new issue, rather than allow the trigger to come into action.
Bail-ins are mechanisms to require the bondholder to recapitalize the bank when it
approaches the point of failure. They can come in two versions, contractual or statutory.
With the contractual version, the extent of requirement for the bondholder to meet theresidual costs of the failure (after the bank reaches the near point of failure) is set out inadvance in the prospectus and documentation (and is thereby limited). In this respect, it
is akin to a CoCo with a very low (zero equity price) trigger.
With a statutory bail-in, the government assesses the residual loss to be met, plus
the need for recapitalization, and then allocates the required burden across the various
categories of bondholder in order from the most junior to the most senior. To avoid
uncertainty, the principles to be followed would have to be clearly and publicly established in advance, probably incorporated into legislation since it involves the authorities
encroaching on private property rights.
The newfound enthusiasm for imposing (some significant part of) the cost of failureon the bondholder extends beyond bank bondholders to holders of government bonds.
All member countries of the eurozone are to include collective action clauses (CACs)
into their sovereign bonds from 2013 onward. The idea is that CAC bonds will be considerably easier to restructure, that is, to impose a partial default, than bonds without
such clauses.
In view of the disadvantages of the other methods for handling failing banks, one
can see why this proposed alternative has been greeted so warmly at least in Europe.
But it too has numerous problems. For example, poorly chosen settings for CoCos could
make fragility worse rather than improve it. Next, if the authorities were to allow otherbanks or levered financial intermediaries to hold CoCos or bank bonds subject to bailin, the potentiality for contagion and falling rows of dominoes is obvious. So if theholders are to be restricted to pension, hedge, and sovereign wealth funds or insurancecompanies, then the market could be rather thin. Moreover, the ultimate beneficiaries
of such intermediated funds are much the same set of people as taxpayers. It is notnecessarily clear that switching the burden of preventing liquidation from the taxpayer
to the fund beneficiary will be politically much more palatable. It may seem so inadvance when few such imposed losses of value have yet been suffered, but it may
look quite different after the event.
But the most serious problem, in our view, is that of contagion, and the danger ofmaking a crisis worse rather than better. Too often, the pros and cons of schemes like
CoCos and bail-ins are discussed in the context of a single failing SIFI rather fromthe standpoint of the system as a whole. In general, a well-designed CoCo or bail-in
mechanism does have much to recommend it in the context of a single failing bank(or eurozone government).
But the systemic problems could be acute. The failure of a single financial intermediary, even quite a large one (e.g., the Bank of Credit and Commerce International orBarings), is not that serious a problem if its cause was clearly idiosyncratic, sui generis.
Most severe crises, however, are caused by common shocks. So if a CoCo or a bail-in
gets triggered for one bank, it will raise the likelihood of it taking place at other banks.
But no one will be sure of what the probability might be. So hedging on CDS and65

short sales would increase. Moreover, the cost of issuing new CoCos and bail-in bonds
for other banks subject to the common shock would rise sharply. So long as senior
bondholders thought that they would not be subject to loss in the event of a default,then banks (and eurozone governments) could refinance themselves in the markets,
even if they were under some suspicion. In the aftermath of the 2007–08 crisis, manybanks resorted to debt issues to meet their funding needs. Would they have been able to
do so, and at what price, if the bonds to be issued were subject to bail-in?
Markets can dry up and become dysfunctional when faced with the prospect of uncertain loss. Do we really want that to happen for the bank (and eurozone government)
bond markets? The authorities could perhaps respond in the face of a generalized crisis
by making the bonds issued during the duration of the crisis guaranteed against loss.
But unless the world were lucky, the proportion of bail-in bonds then might be so smallthat the loss imposed on them for recapitalization would have to be large, perhaps solarge as to sully the reputation of the asset category for a long time.
A besetting weakness of our regulatory approach has always been that it has focusedon resolving the problems of the individual bank, rather than those of the wider financial
system. We are concerned that the move toward requiring banks to issue CoCos andbail-in bonds may have the same flaw.
In our view, the conceptually best approach to dealing with banking fragility thathas been tried was to impose a regime of PCA, as set out under the Federal Deposit
Insurance Corporation Improvement Act (FDICIA) of 1991. This not only set out acarefully considered and graduated ladder of sanctions as tier 1 capital fell below afully adequate leverage ratio, but also required banks either to recapitalize or be closed
when their leverage ratio fell below 2 percent, with the aim of never leaving a loss that
other parties, for example, taxpayers or bondholders, would have to bear.
Yet this failed in 2008. Banks that failed generally had accounting capital, at their
final audit, not only over the 2 percent limit but even on average higher than the comparable banks that did not fail (Haldane [2011]). Losses were recorded by the FDIC inresolving these failing banks. The approach was right, but the practice was deficient.
As has now been frequently pointed out (Calomiris [2011]), market equity prices gavea much better guide to future failure than tier 1 accounting data. The latter involve someconsiderable delay (lags) and can be manipulated.
Simply switching from an accounting measure to a market measure for a leverage
ratio would, however, lead to other problems. Market prices can to some extent be
manipulated, and the use of a market measure would feed the hysteria about short sales.
Then there is the problem of a flash crash; while if one responded to it by making themarket price trigger depend on averaging over a certain number of days, how would theaveraging be done? It could lead to a “sword of Damocles” effect on the bank involved,
and attempts at end-period manipulation.
Perhaps the best option would be to use a combination of both accounting andmarket price triggers, with a considerably higher accounting ratio, say 4 percent for atangible core equity leverage ratio from the accounting measure and a 2 percent tangible
common equity (TCE) leverage ratio using market prices, averaged over two days. Bothwould have to be broken simultaneously to force PCA.

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The Mayekawa Lecture: The Role of Default in Macroeconomics

Under the FDICIA, a bank that fell below 2 percent would either be recapitalized or
liquidated. In view of the costs of liquidation, we would propose that the bank either berecapitalized, or taken over by the government. One of the errors of handling the recent
crisis was that political ideology prevented the government in either the United States or
the United Kingdom from taking failing banks into temporary public ownership. Fear of
the word “nationalization” was too great. But when banks get into such straits, not only
should the management team and the board of directors be removed, but also existing
shareholders should be expropriated. As soon as practically possible, the bank should besold back to the private sector. If the receipts from such sales exceed the government’s
costs and a reasonable rate of return on the interim investment of public-sector money,
then the excess could be distributed to the prior shareholders.
A reformed and improved PCA mechanism should be able to cope with most banking problems, and a combination of living wills and special resolution regimes should
enable the authorities to better handle the few that are so sudden and catastrophic thatthey are not picked up by the reformed PCA. Yet this is not the direction in which theregulatory authorities appear to be moving. In our view, bank resolution procedures willremain problematical both in the United States and Europe, though in different ways.

67

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