Bernanke was at the forefront of this research. My favorite
Bernanke paper (with Mark Gertler) argued that the boom-bust cycle might be
worsened by Luthor's Law.
In their model, just like in the real world, the people with
money are rarely the people with good ideas.
But if the Money People lend to the Idea People in hopes of earning a profit,
the Idea People might just spend it all on high salaries, ping-pong tables, and
jobs for their friends. After the money
is spent, the Idea People can write in their annual report, "Things just didn't
work out." Alas, but what can you do?
Here's where the climax of Luthor's speech kicks in: "People
will always need land... Remember, my father said, Land." One reason people need land is because it makes great
collateral, at least in countries with good
legal systems. If an entrepreneur
can bring some collateral to the table (land, bonds or stock in our day; in
medieval Europe, a
hostage) and credibly promise to hand it over to the Money People if things
go south, then the trust problem---well, it won't be solved, but now the relationship at least has a fighting chance.
And in the real world, the Idea People use their home equity quite
often: the Cleveland
Fed says that 25% of new small businesses either pledge their homes as
collateral or use a home equity line to get their businesses going.
Well, they used to
anyway: since the recession, the same report says that business owners "faced
demands for more collateral by lenders" and found it harder to use residential
or commercial real estate as collateral.
The lesson: When the price
of collateral falls, the quantity of
trust falls. Less home equity (and less stock market equity) means less lending
by the Money People. And less trust.
And when the quantity of trust falls, the Money People go
back to running safe,
low-return projects, the kind that don't depend on trust, on
trustworthiness. Worse, since the Idea
People aren't making money, they'll find it harder to build up collateral, so
that means less trustworthiness, less lending, far into the future.
Maybe that helps to explain why one-time shocks to the economy have
effects that last for years and years: A one-time shock to collateral causes a long-lasting
fall in trustworthiness, and a persistent loss of promising ideas. Another reminder that Real Business Cycles