Debt rigidity crisis
Salman Najafov
Abstract
paper demonstrates that debt crises are caused by debt rigidity. It is noted that similarly to wage and price rigidity debt rigidity makes markets unable to adjust quickly and adequately to the shocks in economy. It is justified that to make companies and banks more flexible and resistant to shocks, companies liabilities similarly to income and assets price should be flexible. Paper argues that crisis in Japan and banking fragility in US and euro area countries are caused by debt rigidity, and these problems can be solved by liability flexibility which can be provided by profit participating financing.classification: G01: debt crises, debt rigidity, profit/loss sharing financing
Introduction
One of the main factors of effectiveness of firms and economy in whole is its flexibility or ability to adjust quickly and adequately to the shocks in economy. In particular the key factor of flexibility of firms is price and wage flexibility. The presence of nominal rigidity is an important part of macroeconomic theory since it can explain why markets may not reach equilibrium and face crisis.exists in financial sector too. This is debt rigidity which similarly to wage and price rigidity makes markets unable to adjust quickly and adequately to the shocks in economy. Debt rigidity can be expressed in the following way: though income and asset price of economic agents are flexible and decrease during recession, their debts don t decline. This downward debt rigidity restricts the ability of debtors to fulfill debt obligations and leads to debt crisis.rigidity causes a debt crisis not only during recession but during economic rise too. So during economic rise when companies incomes and asset prices increase but they liabilities remain, the value of external financing becomes less than value of internal financing that increases demand for credit. And this credit boom as it was shown by Austrian school creates the prerequisites for debt crisis.
To make real sector more flexible and able to adjust quickly and adequately to the shocks, companies liabilities similarly to income and assets price should be flexible. Liability flexibility can be provided by profit/loss sharing. Profit participating financing will strengthen stability of banks too as money attracted by banks are not debt but trust account or money transferred to bank in trust.rigidity negatively influences lending too. It can be seen in Japan where, on the one hand the companies, because of the fear that incomes and value of assets in the future will be insufficient for repayment of debts, reduce demand for credits. On the other hand banks also because of risks to face insolvency to depositors tighten the requirements for debtors and so decrease the lending. Thus the reluctance of both firms to borrow and banks to lend may be overcome by profit participating financing.
We start in this paper with a description of how debt crises occur. We then show that Japanese crisis is caused by debt rigidity. Then it is argued that because of debt rigidity banking sector in US and euro area is also vulnerable to crisis.
Debt rigidity as the cause of debt crises
Why do debt crises take place? It is obviously that debt crisis is the inability of debtors to fulfill obligations to creditors. There are some reasons why debtors face debt problems. Among them decline in asset prices, malinvestment lt; # justify" gt; To make real sector resistant to shocks, companies liabilities similarly to income and assets price also should be flexible. Liability flexibility may be provided by profit/loss sharing financing. As a result of flexibility of liabilities, companies and real sector in whole will be more flexible and respond to economic shocks better. Profit participating financing will strengthen stability of banks too as money attracted by banks are not debt but trust account or money transferred to bank in trust, and yield from operation is divided between owner of money and manager (bank).
Thus profit/loss sharing will provide more equitable distribution of risks and losses between companies, banks and depositors and so prevent the concentration of risk, which will make the financial system more stable.
Debt rigidity causes a debt crisis not only during recession but during economic growth too. So during economic growth when companies incomes and asset prices increase but they liabilities remain, the value ...
