Economic theory has formalized the notion that monetary trade may benefit society. In the presence of frictions, money can expand allocations by facilitating spot trade. A key element is difficulties in carrying out intertemporal trades, originating from society’s incapacity to enforce contracts, agents’ inability to commit to future actions, and unobservability of trading histories (Kocherlakota, 1998).
Recent work has relaxed some of these assumptions to study how the availability of credit affects allocations and the role of money. Despite the different approaches adopted, a common feature exists: default is either ignored or inconsistent with equilibrium.
We study an economy with trade frictions where agents choose between spot exchange and intertemporal trade that can be risky, as borrowers may intentionally default. Our goal is to understand whether the incapacity to enforce contracts is a sufficient threat to the existence of credit, and whether intentional default can be an equilibrium phenomenon. In particular, we want to investigate the links between equilibrium credit risk and the liquidity value of credit instruments, letting money and private liabilities be free to compete as media of exchange. If equilibria with different degrees of default risk coexist, we then ask which one is socially preferred.
We work within a general equilibrium framework where trading difficulties enforcement, commitment, and record-keeping limitations are made explicit. Intermediation is key to supporting intertemporal trade, and money is valued according to its ability to facilitate spot trade. To make the analysis transparent, we build an economy without sophisticated financial markets, and model trade as a matching process. There are two competing trading sectors: a spot market, where trade is quid-pro-quo, and a credit market where trade is a sequence of unilateral transfers. In each market transactions are bilateral, one per period, and prices are endogenously formed via take-it-or-leave-it offers from consumers to producers.
Intertemporal trade can exploit the record-keeping, monitoring, and punishment technology of an ‘intermediary.’ Default may arise due to monitoring imperfections. The intermediary can temporarily exclude defaulters from credit trades, and can make collections on defaulted debts. It can also ‘secure’ back) private loans by issuing a ‘security’ in case of default. This is a stochastic consumption claim whose payoff is financed through collections on defaulted debt.
This activity of the intermediary essentially amounts to an asset transformation process, converting bad loans into securities. If spot markets are active, unmatured securities may thus be traded, providing additional liquidity to the economy. The expected return on a loan, thus accounts for the securities’ intrinsic worth and extrinsic liquidity value.
In equilibrium, the extent of spot and credit trade depend on their expected returns. These hinge on two aggregate state variables: default risk and spot trade difficulties. The first is entirely endogenous, the second depends also on available liquidity. Thus, equilibrium credit risk and liquidity are closely intertwined.
Equilibrium default can arise, if there is limited recourse against defaulters. In this case spot and intertemporal trade may coexist, with securities circulating along with money and dominating it in rate of return. Here, some agents are indifferent between spot exchange, where they face consumption risk, and intertemporal exchange, where they face default risk. Therefore, high default rates can be sustained only if securities backing the loans have sufficiently high expected return.
Since the medium-of-exchange use of securities lessens spot trade frictions, a prohibition of their circulation may have noxious effects when the stock of outside money is limited. However, credit can also be sustained in the absence of secured loans, if defaulters can be easily excluded from future access to credit markets.
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