Debt rigidity crisis

Debt rigidity crisis

Debt rigidity crisis

Salman Najafov

Abstract

paper demonstrates that debt crises are caused by debt rigidity. It is noted that similarly to wage and price rigidity debt rigidity makes markets unable to adjust quickly and adequately to the shocks in economy. It is justified that to make companies and banks more flexible and resistant to shocks, companies’ liabilities similarly to income and assets price should be flexible. Paper argues that crisis in Japan and banking fragility in US and euro area countries are caused by debt rigidity, and these problems can be solved by liability flexibility which can be provided by profit participating financing.classification: G01: debt crises, debt rigidity, profit/loss sharing financing

Introduction

One of the main factors of effectiveness of firms and economy in whole is its flexibility or ability to adjust quickly and adequately to the shocks in economy. In particular the key factor of flexibility of firms is price and wage flexibility. The presence of nominal rigidity is an important part of macroeconomic theory since it can explain why markets may not reach equilibrium and face crisis.exists in financial sector too. This is debt rigidity which similarly to wage and price rigidity makes markets unable to adjust quickly and adequately to the shocks in economy. Debt rigidity can be expressed in the following way: though income and asset price of economic agents are flexible and decrease during recession, their debts don’t decline. This downward debt rigidity restricts the ability of debtors to fulfill debt obligations and leads to debt crisis.rigidity causes a debt crisis not only during recession but during economic rise too. So during economic rise when companies’ incomes and asset prices increase but they liabilities remain, the value of external financing becomes less than value of internal financing that increases demand for credit. And this credit boom as it was shown by Austrian school creates the prerequisites for debt crisis.

To make real sector more flexible and able to adjust quickly and adequately to the shocks, companies’ liabilities similarly to income and assets price should be flexible. Liability flexibility can be provided by profit/loss sharing. Profit participating financing will strengthen stability of banks too as money attracted by banks are not debt but trust account or money transferred to bank in trust.rigidity negatively influences lending too. It can be seen in Japan where, on the one hand the companies, because of the fear that incomes and value of assets in the future will be insufficient for repayment of debts, reduce demand for credits. On the other hand banks also because of risks to face insolvency to depositors tighten the requirements for debtors and so decrease the lending. Thus the reluctance of both firms to borrow and banks to lend may be overcome by profit participating financing.

We start in this paper with a description of how debt crises occur. We then show that Japanese crisis is caused by debt rigidity. Then it is argued that because of debt rigidity banking sector in US and euro area is also vulnerable to crisis.

Debt rigidity as the cause of debt crises

Why do debt crises take place? It is obviously that debt crisis is the inability of debtors to fulfill obligations to creditors. There are some reasons why debtors face debt problems. Among them decline in asset prices, "malinvestment <#"828353.files/image001.gif">

Figure 1. Nikkei index and the dynamics of land prices in Japan

rigidity and banking problems in US and euro area countries

debt rigidity crediting  crisis

Debt rigidity problem is urgent for US and European countries too. As it can be seen from figure 2 the share of securities in banking assets in US is 19%, in some euro area countries this figure is about 35%. Taking into consideration record low interest rate in US and euro area (figure 3 and 4) it is obvious that expected rise in interest rate will have negative effect on banking sector, because rise of interest rate will decrease the value of securities banks hold and so will make difficulties for them to fulfill their obligations towards depositors and other creditors.

2. Share of debt securities in total assets of banking sectors in US (July 2014) and euro area (2012), percentage of total assets, 2012

3. Federal Funds Rate, end of period, %

4. ECB interest rate

Conclusion

to wage and price rigidity debt rigidity restricts flexibility of markets and makes them unable to adjust quickly and adequately to the shocks in economy. To make real sector more flexible and resistant to shocks, companies’ liabilities similarly to income and assets price should be flexible. Liability flexibility can be provided by profit/loss sharing. Profit participating financing will strengthen stability of banks too as money attracted by banks are not debt but trust account or money transferred to bank in trust.rigidity negatively influences lending too. On the one hand the companies, because of the fear to face insolvency on loans, reduce demand for credits. On the other hand banks also because of risks to face insolvency to depositors tighten the requirements for debtors. Thus the reluctance of both firms to borrow and banks to lend may be overcome by profit participating financing.

Debt rigidity problem is urgent for US and European countries too. Taking into consideration near-zero interest rate in US and euro area it is obvious that expected rise in interest rate will decrease the value of securities banks hold and so will provoke banking crisis.