Olivier Jeanne, who teaches two popular courses for the financial econ. minor, is doing some interesting research on private debt and economic stability with Anton Korinek (U. Maryland). The work demonstrates how rising asset prices in a boom involve an economic externality implying that credit is priced below its true social cost. The lesson is the same as with other externalities such as pollution: when things are priced below their social cost, we tend to get too much of them and there is a case for some sort of government intervention. Economists most often advocate some sort of fee or tax that raises the cost to the firm to something close to the social cost. Thus, we advocate a pollution fee or, equivalently, a fee on use of credit in a boom.

In the case of credit, Jeanne and Kornik’s reasoning adds an important element to the reasoning for all prudential regulatory policy in the financial sector. Firms do not take into account the systemic, social cost of their own failure. In fact, corporate firms have a fiduciary responsibility to ignore such costs in the name of maximizing value for shareholders. Of course, this problem is magnified if bailouts may be forthcoming. Thus, the firms will take excess risks from a social perspective. What Jeanne and Korinek add is that the magnitude of the externality grows in booms and shrinks in busts. Thus, a policy response that is constant over time is inappropriate. They explore what sort of dynamic tax or fee might be appropriate in the context of a simple macroeconomic model.

Jeanne and Korinek summarize their research in an very useful online publication called VOX. The article is Managing credit booms and busts. You can also check out the underlying research paper.

Let me put in a plug for VOX. Top economists summarize their policy-related research in an accessible way on VOX. For example, another recent piece is on the financialization of commodities–the fact that hundreds of billions of dollars of investment dollars have flowed into commodities in recent years as a broader range of investors have sought exposure to commodities. VOX has lots of high quality yet accessible analysis.