Overborrowing, Financial Crises and 'Macro-Prudential' Taxes

Abstract

An equilibrium model of financial crises driven by Irving Fisher's financial amplification mechanism features a pecuniary externality, because private agents do not internalize how the price of assets used for collateral respond to collective borrowing decisions, particularly when binding collateral constraints cause asset fire-sales and lead to a financial crisis. As a result, agents in the competitive equilibrium borrow "too much" ex ante, compared with a financial regulator who internalizes the externality. Quantitative analysis calibrated to U.S. data shows that average debt and leverage are only slightly larger in the competitive equilibrium, but the incidence and magnitude of financial crises are much larger. Excess asset returns, Sharpe ratios and the price of risk are also much larger, and the distribution of returns displays endogenous fat tails. State-contingent taxes on debt and dividends of about 1 and -0.5 percent on average respectively support the regulator's allocations as a competitive equilibrium.