Thinking about contingencies, designing covenants, and seeing through their implications is costly. Parties to a contract accordingly use heuristics and leave it incomplete. The paper develops a model of limited cognition and examines its consequences for contractual design.

Concerns of pride, dignity, and the desire to keep hope about future options often lead individuals and groups to walk away from rea sonable offers, try to shift blame for failure onto others or take refuge in political utopias. Costly impasses and conflicts result, such as trials, divorces, strikes, the scapegoating of minorities for economic hardships, and wars. A key and puzzling aspect of these processes is the role played by wishful rationalizations and delusions, as attested by field observers (e.g., Truman F. Bewley (1999) in the context of labor relations; Kevin Woods, James Lacey, and Williamson Murray (2006) in that of war), as well as controlled experiments. Leigh Thompson and George Loewenstein (1992) and Linda C. Babcock et al. (1995) thus demonstrate how subjects in bargaining situations with common knowledge spontaneously generate, through self-serving processing and recall of the same evidence, divergent beliefs about the fairness of their cause and wishful predictions of outcomes, and how these are associated to costly delays and disagreements.

Among the many unusual aspects of the ongoing financial crisis is the unprecedented provision of backstop liquidity by central banks around the world. The Federal Reserve alone had committed $4,400 billion by mid-Novem ber 2008. The Fed funds rate is almost equal to zero. These are extraordinary numbers. This paper establishes a formal relationship between the recent monetary developments and the trends in private leverage and its structure. Over the last few years, some traditional insti tutions, for example broker-dealers, have relied more and more on markets (securitization, money market ) for their funding. Some banks have also increased their dependence on mar kets; the standard illustration is Northern Rock, a UK mortgage bank, which prior to its bailout relied on short-term wholesale markets for 75 percent of its funding. A second factor contributing to the reliance on wholesale markets is the overall shift from a bank-based system to a market-based one. The expanding so-called “shadow banking system” (conduits, hedge funds, investment banks, monolines ) has engaged in substantial transfor mation and, unlike commercial banks, could not avail itself of stable insured deposits. Mutual funds are under the threat of redemptions and may well face liquidity shortages as well. Adding subprime borrowers, who are heavily dependent on high housing prices and, for those with adjustable-rate mortgages (ARMs), on low short-term interest rates, and highly lever