Understanding Macroeconomic Fragility

This research project provides insights into how the lending market and resale market for asset-backed securities could have broken down during the 2008-2009 financial crisis, leading to a near-collapse of the banking sector and to a significant decline in real loan activity.

The 2008-2009 worldwide financial crisis has reminded us all that economic systems can be quite fragile. Understanding this fragility is crucial not only for formulating appropriate policy responses and strategies for the future, such as macro-prudential regulation, but also for identifying the private-sector risks and opportunities arising out of this fragility. This project explores how the lending and resale markets for asset-backed securities led to a near-collapse of the banking sector during the financial crisis, and the key will be the sudden realization by market participants that these assets differ in quality, thereby throwing sands in the wheels of short-term financing of these asset trades. The project also investigates market “liquidity,” market “freezes,” and “overheating,” using concepts developed in statistical mechanics for similar phenomena in physics, to provide deeper insights into these phenomena and their macroeconomic implications.