1University of Virginia, Department of Economics, Monroe Hall, 248 McCormick Road, Charlottesville, VA, 22903 (e-mail: [email protected])
2Yale University, Department of Economics, 30 Hillhouse Avenue, New Haven, CT, 06511; Santa Fe Institute, 1399 Hyde Park Rd, Santa Fe, NM 8750 (e-mail: [email protected])
Abstract
Financial innovations that change how promises are collateralized affect prices and investment, even in the absence of any change in fundamentals. In C-models, the ability to leverage an asset always generates overinvestment compared to Arrow-Debreu. Credit Default Swaps always leads to underinvestment with respect to Arrow-Debreu, and in some cases even robustly destroy competitive equilibrium. The need for collateral would seem to cause under-investment. Our analysis illustrates a countervailing force: goods that serve as collateral yield additional services and can therefore be over-valued and over-produced. In models without cash flow problems there is never marginal underinvestment on collateral. (JEL D52, D86, D92, E44, G01, G12, R31)