Japan has been in a slump for the past decade. After GDP had been growing by on average 4 percent during the 1980’s, the growth rate dropped to 1 percent in the 1990’s. Asset prices also fluctuated significantly: capital gains on stocks and real estate in the 1980’s, followed by capital losses in the 1990’s, were both on the order of a few years’ worth of GDP, even after taking inflation into account. Together with production and asset prices, the fraction of nonperforming loans fluctuated substantially. These are by no means all bank loans. For the nonfinancial corporate sector in Japan, the ratio of financial assets to total assets is about 40 percent, much higher than in the United States. Such financial assets include loans to and securities of other private agents. That is, nonfinancial institutions simultaneously borrow from and lend to each other on a significant scale. Many nonperforming loans are interlocked, paralyzing the financial system. It is important to recognize that these swings have been experienced by almost all sectors of the Japanese economy. Yet in other countries, comparable movements in asset prices have had less widespread consequences. For example, the recent fluctuations in the NASDAQ index in the United States have been no smaller than those of asset prices in Japan, but the damage appears to be contained to closely related sectors. Although U.S. equity-holders, particularly pension funds, have lost value, the level of nonperforming loans is relatively limited up to now. The question is: Why does there appear to be more contagion in some countries than in others? Has contagion anything to do with the nature of financing or the extent to which there are inter-locking loans? In this theoretical paper, we examine two different mechanisms by which contagion may occur. In both cases, propagation is through balancesheet effects. First, through the indirect effects that fluctuations in asset prices have on collateral values. Second, through the direct effects that default on or postponement of debt repayments have when there are chains of credit.

Plenary talk delivered at the annual meeting of the Society for Economic Dynamics.(This abstract was borrowed from another version of this item.)

We argue that long-term debt has a role in controlling management's ability to finance future investments. Companies with high (widely held) debt will find it hard to raise capital, since new security-holders will have low priority relative to existing creditors; conversely for companies with low debt. We show that there is an optimal debt--equity ratio and mix of senior and junior debt if management undertakes unprofitable as well as profitable investments. We derive conditions under which equity and a single class of senior long-term debt work as well as more complex contracts for controlling investment behavior.

Version of Record

Using Pareto optimality (in the HicksKaldor sense) as their criterion throughotut, Kenneth Arrow and Robert Lind argue in the June 1970, issue of this Review that 1) for public investments the cost of risk-bearing should be regarded as zero because this cost is spread over a large number of persons; 2) consequently, public investment should displace private investment if the expected rate of return exceeds the expected return to private investment minus an adjustment for the cost of risk-bearing; 3) furthermore, project costs borne publicly or benefits accruing to government should be discounted at relatively low rates (because the cost of risk-bearing, is low if spread among large numbers of persons), but project costs borne privately or benefits accruing to private individuals should be discounted at relatively high rates. Arrow and Lind are abstracting from other factors, e.g., externalities, public good characteristics, or ideological preferences for either state or private activity, that might also affect the choice between public and private investments. We wish to emphasize anew the fundamental defect in anv proof that a policy yields a Hicks-Kaldor improvement. We are not referring to the objection to the Hicks-Kaldor criterion-the fact that without actual compensation there will be a redistribution to which one may attach negative value. (Arrow and others have stressed that for this reason one cannot say that a Hicks-Kaldor change is a gain in welfare.)' We are referring rather to the fact that, without actual purchase of everyone's consent, one lacks information about whether the gains exceed the cost, i.e., about whether it would in fact be possible to make some better off without makingr anyone worse off.2 One may judge that a policy, such as public investment, would be a Hicks-Kaldor improvement because he believes the relevant tradeoffs in individuals' preference surfaces are such as to make the gains exceed the costs (as seen by each individual for himself). But he cannot show others that this is so: a Hicks-Kaldor improvement is by definition a change such that one can never demonstrate that it is a Hicks-Kaldor improvement! The Arrow-Lind argument is in difficulty this score because of the alternatives it considers, a public investment financed by taxes versus a private investment. In the latter case, individuals invest voluntarily, taking into account their marginal time preferences as well as their risk preferences. In a public investment financed by taxes, people are forced to invest. One has no observable data on whether all of these individuals would be willing to invest rather than consume, or data on how much thev would have to be paid to invest voluntarily.3 Some of them might much prefer to consume, given the circumstances assumed by Arrow and Lind: At the margin, different