Media Briefings

Averting Economic Armageddon With A ‘Super Chapter 11’

  • Published Date: May 2010

A ‘super Chapter 11’ – akin to US procedures for restructuring businesses’ balance sheets after bankruptcy – could play a crucial role in preventing an asset price correction triggering widespread economic collapse. That is the conclusion of research by Professors Marcus Miller and Joseph Stiglitz, published in the May 2010 issue of the Economic Journal.

The researchers also call for a restructuring of the conventional paradigm of modern macroeconomics. Neither liquidation nor restructuring plays a significant role in standard macroeconomic models, one reason, perhaps, why they fail to capture the nature of the current crisis.

In mid-2008, Paul DeGrauwe warned of the danger that: ‘the macro­economic models now in use in central banks operate like a Maginot line. They have been constructed in the past as part of the war against inflation. The central banks are prepared to fight the last war. But are they prepared to fight the new one against financial upheavals and recession? The macroeconomic models they have today certainly do not provide them with the right tools to be successful.’ (Financial Times, July 2008)

Miller and Stiglitz argue that the macroeconomic framework relevant for the present should include balance sheets and the problems that may arise from high debt – particularly when collateral assets are falling in value – and should allow for the role of capital restructuring in crisis resolution.

It is sometimes said that: ‘Capitalism without the threat of bankruptcy is like Christianity without the threat of hell’. And the prospect of liquidation (under Chapter 7 of US law) is, of course, a powerful sanction on firms working with borrowed capital.

But bankruptcy is a two-way street: firms that face temporary difficulties can file for protection against their creditors so as to restructure their balance sheets and keep their businesses going. Court-supervised debt-equity swaps (under Chapter 11) have kept airlines flying in the United States, for example.

Neither liquidation nor restructuring plays a significant role in standard macroeconomic models, however – one reason, perhaps, why they fail to capture the nature of the current crisis. While the operation of these legal provisions offers an insight into the threat facing many businesses at the present time (and the role of restructuring in keeping them going), it has to be said that nationwide problems may exceed the capacity of individual courts.

For macroeconomic shocks, official intervention along similar lines – organising restructuring under what Miller and Stiglitz call ‘super Chapter 11’ – may be necessary.

In current macroeconomic models, it is fashionable to imagine that decisions are made by a ‘representative agent’ with rational (unbiased) expectations.

For the purpose at hand – to study the dangers posed by ‘excessive leverage’ and how emergency capital reorganisation can help – these researchers turn instead to a model of ‘heterogeneous agents’ – wealth-owners with ‘deep pockets’ who face diminishing returns and productive borrowers running small businesses who have constant returns but need to secure their debts by collateral. And they allow for an asset bubble in the value of collateral.

As an iconic representation of a highly leveraged economy, the study uses the framework of Kiyotaki and Moore (1997) where the dumping of collateral generates significant negative externalities. Their approach was originally designed to show that technology shocks would have more persistent real effects than foreseen in the real business cycle literature.

To accommodate current developments, Miller and Stiglitz consider how the collapse of an asset bubble can threaten industry-wide liquidation: and they study the role of capital restructuring in ‘averting Armageddon’.

The usual court-ordered ‘bankruptcy’ procedures for doing this are not designed to handle macroeconomic shocks hitting the whole economy and fail to internalise the price effects of asset ‘fire-sales’ required to satisfy margin calls.

So they discuss how ‘super Chapter 11’ procedures can play a crucial role in preventing an asset price correction triggering widespread economic collapse; and how timely cuts in interest rates – which act as transfers from lenders to borrowers – can also help.

They conclude:

‘To cope with the financial shock, balance sheets may need prompt ‘restructuring’. Time for the conventional paradigm of macroeconomics to receive similar treatment?

ENDS

Notes for editors: ‘Leverage and Asset Bubbles: Averting Armageddon with Chapter 11?’ by Marcus Miller and Joseph Stiglitz is published in the May 2010 issue of the Economic Journal.

Marcus Miller is at the University of Warwick. Joseph Stiglitz is at Columbia University.

For further information: contact Marcus Miller on 02476-523049 (email: marcus.miller@warwick.ac.uk); or Romesh Vaitilingam on 07768-661095 (email: romesh@vaitilingam.com).