Martin Hellwig

Incentive-Compatible Debt Contracts: The One-Period Problem

In a simple model of borrowing and lending with asymmetric information we show that the optimal, incentive-compatible debt contract is the standard debt contract. The second-best level of investment never exceeds the first-best and is strictly less when there is a positive probability of costly bankruptcy. We also compare the second-best with the results of interest-rate-taking behaviour and consider the effects of risk aversion. Finally we provide conditions under which increasing the borrowers initial net wealth must reduce total investment in the venture.

The macroeconomic implications of capital adequacy requirements for banks

Abstract Capital adequacy regulation for banks may reinforce macroeconomic fluctuations: If negative shocks to aggregate demand reduce the ability of firms to service their debts to banks, this reduction in debt service lowers bank equity, and, because of capital adequacy requirements, this in turn reduces bank lending and industry investment.

Liquidity provision, banking, and the allocation of interest rate risk

Abstract The paper studies the efficient allocation of technology-induced interest rate risk and the implications of such risk for efficient liquidity provision. Complete immunization against interest rate risk is shown to be undesirable as it precludes the exploitation of favourable reinvestment opportunities. Under the assumptions of Diamond-Dybvig (1983), interest-induced valuation risks of long-term assets should be born by early withdrawers, reinvestment opportunity risks of short-term assets by late withdrawers. Efficient liquidity provision thus entails no shifting of interest rate risk. In the absence of additional moral hazard, second-best allocations can be implemented through unregulated competition among banks.

Bertrand-edgeworth oligopoly in large markets

The relation between perfectly competitive and monopolistically competitive equilibria is analysed for a Bertrand-Edgeworth model of a single market in which capacity constrained firms choose prices as strategies. The market always has a Nash equilibrium in pure or mixed strategies. As the number of firms increases, the corresponding equilibria converge in distribution to a perfectly competitive price. This result provides a justification for perfect competition that is based on an explicit account of price formation. However, monopoly prices persist with a positive but vanishing probability. Regularity or well defined inverse demand functions are not required.

Rational Expectations Equilibrium with Conditioning on Past Prices: A Mean-Variance Example

An electrically heated cooking grill for rapidly cooking cheese sandwiches, hamburgers, french toast, bacon, pancakes, crepe suzette (thin pancakes), pizza crust, scrambled eggs, and other food products. The food products are conveyed between a pair of endless heating belts which are heated by upper and lower heating units in the form of heating platens which have variable temperature heating zones so arranged that the cooking temperature is varied as the food product moves through the variable temperature heating zones. The upper heating unit includes front and rear upper heating platens which are vertically adjustable with the upper heating belt relative to the lower heating unit or platens and heating belt to provide for food products of varying sizes and thicknesses and the front and rear upper heating platens may be tilted relative to the horizontal so that as the food product moves progressively through the grill from front to rear and shrinks in size due to the cooking operation the front and rear upper heating platens and the upper heating belt will be disposed in the most advantageous heating position relative to the lower heating belt and heating unit or platens. The endless heating belts are designed to be nonsticky and to provide for rapid heat transfer from the heating units or platens to the food products being cooked and for long wear life.

Capital Regulation after the Crisis: Business as Usual?

The paper discusses the reform of capital regulation of banks in the wake of the financial crisis of 2007/2009. Whereas the Basel Committee on Banking Supervision seems to go for marginal changes here and there, the paper calls for a thorough overhaul, moving away from risk calibration and raising capital requirements very substantially. The argument is based on the observation that the current system of risk-calibrated capital requirements, in particular under the model-based approach, played a key role in allowing banks to be undercapitalized prior to the crisis, with strong systemic effects for deleveraging multipliers and for the functioning of interbank markets. The argument is also based on the observation that the current system has no theoretical foundation, its objectives are ill-specified, and its effects have not been thought through, either for the individual bank or for the system as a whole. Objections to substantial increases in capital requirements rest on arguments that run counter to economic logic or are themselves evidence of moral hazard and a need for regulation.

Moral Hazard and Equilibrium Credit Rationing: An Overview of the Issues

One of the more intriguing puzzles in microeconomics is presented by the phenomenon of credit rationing. If funds are so scarce as to require rationing, why do lenders not raise the interest that they demand? We survey recent developments that seek to explain this phenomenon by appealing to incentive problems in the relation between the borrower and the lender. A simple example, due to Stiglitz and Weiss, shows that under certain circumstances, lenders will not use their bargaining power to raise interest rates because the adverse incentive effects of such a move outweigh any direct effect on the lender’s payoffs. To examine the robustness of this argument, we discuss how the analysis is affected by the use of collateral, variations in loan size and investment, or alternative forms of the finance contract. Finally, we analyse the relation between the credit-rationing problem and the general theory of optimal incentive schemes under imperfect information.

The challenge of monetary theory

Departing from custom, I want to address a problem that needs to be solved rather than one that has been solved. I do not have much to contribute to its solution, but I believe that the problem is important and want to focus attention on it. In general terms, the problem is to find appropriate conceptual foundations for monetary economics. I believe that we do not, as yet, have a suitable theoretical framework for studying the functioning of a monetary system. The main obstacle to the development of such a framework is our habit of thinking in terms of frictionless, organized, i.e. Walrasian markets. The problem is partly a problem of language. The central concepts of economics, demand, supply, and price, are concepts that presuppose a system of centralized Walrasian markets. We are used to thinking in terms of these concepts, and we tend to apply them rather automatically to the ‘market’ for money, frequently without realizing that the ‘market’ for money must be a rather non-Walrasian ‘market’, if indeed it can be called a ‘market’ at all. More or less all the models of monetary economics that are being used in practice proceed in this way, using artifical adaptations of the Walrasian centralized-markets model to accommodate money without actually giving an account of what the role of money in the economy is. The problem is one of pure economic theory. However, it bears on many important questions of applied economics and economic policy. To study the relation between money, income and prices, we need a framework which gives a satisfactory account of the relation between the monetary system and the price mechanism. To study the effects of central-bank open-market

Endogenous technical change in a competitive economy

We develop a model of endogenous growth in an economy with competitive markets. Technical change arises from the intentional actions of entrepreneurs looking for profits. Opportunities for such profits stem from inframarginal rents. This provides a counterexample to the widespread view that endogenous technical change is possible only if innovating firms can expect to reap monopoly or oligopoly rents. The model has a unique equilibrium, which involves steady growth at a positive rate. Equilibrium growth is inefficiently low because knowledge spillover effects are neglected. The inefficiency can be eliminated by an interest rate subsidy.

Public-Good Provision with Many Participants

For a nonexcludable public good with benefit and cost functions independent of the number of participants, this paper studies second-best allocations under Bayesian interim incentive compatibility and interim individual rationality. As the number of participants becomes large, second-best provision levels converge in distribution to first-best levels if the latter are bounded. Second-best provision levels become large in absolute terms but small relative to first-best levels if benefit and cost functions are isoelastic. In contrast, for an excludable public good, the ratio of second-best to first-best levels is bounded away from zero. Copyright 2003, Wiley-Blackwell.