The Arrow-Debreu model provides the foundation for modern macroeconomic theory and the theory of finance. This is probably as it should be. But like most foundations, it is just a place to start. As John Geanakoplos explains here, the AD model is “relentlessly neoclassical.” And what this means, among other things, is that the basic AD model offers no explanation for phenomena related to money, liquidity, banking, and corporate finance (just to offer a partial list).
To make sense of phenomena like money, liquidity, and collateral, we need to model the “frictions” that make intertemporal trade difficult. Frictions like private information, limited commitment, and limited communication. Absent such frictions, debtors could spend their promises easily. Creditors would not not have to worry about promises being broken. Such a world is not likely be free of the business cycle. But business cycles would likely be muted (small shocks would not be magnified as much, or propagated throughout the economy to the same extent).
Of course, economists throughout the ages have thought about these sort of frictions. And there is a substantial body of modern macroeconomic theory that attempts to formalize these notions. A heretofore neglected area of research, however, is what economists have come to call the “shadow banking” sector (see here, here and here). Some recent theoretical work can be found here:
The shadow banking sector is still very large–take a look at this recent news story: Shadow Banking Still Thrives. According to Gary Gorton (Shadow Banking Must not be Left in the Shadows) the shadow banking sector needs to be regulated…somehow. It seems like we’re still not exactly sure how this should be done or, indeed, if it is even feasible.
What I mean about “feasibility” is the observation that private agents, particularly those in the financial industry, seem to be extremely good at innovating their way around existing bank legislation. Shedding light on one dark place in the room just causes the little critters to find other shadows. Who knows, maybe that’s even a good thing. But I haven’t really seen any theoretical papers on the subject (please send if you have).
Here is Ken Rogoff on the subject: Ending the Financial Arms Race. Here is an excerpt:
Legislative complexity is growing exponentially in parallel. In the United States, the Glass-Steagall Act of 1933 was just 37 pages and helped to produce financial stability for the greater part of seven decades. The recent Dodd-Frank Wall Street Reform and Consumer Protection Act is 848 pages, and requires regulatory agencies to produce several hundred additional documents giving even more detailed rules. Combined, the legislation appears on track to run 30,000 pages.
As Haldane notes, even the celebrated “Volcker rule,” intended to build a better wall between more mundane commercial banking and riskier proprietary bank trading, has been hugely watered down as it grinds through the legislative process. The former Federal Reserve chairman’s simple idea has been co-opted and diluted through hundreds of pages of legalese.
The problem, at least, is simple: As finance has become more complicated, regulators have tried to keep up by adopting ever more complicated rules. It is an arms race that underfunded government agencies have no chance to win.