Economic Theory

, Volume 56, Issue 3, pp 549–583 | Cite as

Consumer default with complete markets: default-based pricing and finite punishment

Research Article

Abstract

This paper studies economies with complete markets where there is positive default on consumer debt. In a simple tractable two-period model, households can default partially, at a finite punishment cost, and competitive intermediaries price loans of different sizes separately. This environment yields only partial insurance. The default-based pricing of debt makes it too costly for the borrower to achieve full insurance, and there is too little trade in securities. This framework is in contrast to existing literature. Unlike the literature with default, there are no restrictions on the set of state contingent securities that are issued. Unlike the literature on lack of commitment, limited trade arises without need of debt constraints that rule default out. Compared with the latter, the present approach appears to imply more consumption inequality. An extended model with an infinite horizon, idiosyncratic risk and more realistic assumptions is used to demonstrate the general validity of this approach and its main implications.

Keywords

Consumer default Complete markets Endogenous incomplete markets Risk-based pricing Risk sharing 

JEL Classification

E21 E44 D52 

References

  1. Ábrahám, Á., Cárceles-Poveda, E.: Endogenous trading constraints with incomplete asset markets. J. Econ. Theory 145(3), 974–1004 (2010)Google Scholar
  2. Alvarez, F., Jermann, U.: Efficiency, equilibrium, and asset pricing with risk of default. Econometrica 68(4), 775–797 (2000)Google Scholar
  3. Andolfatto, D., Gervais, M.: Endogenous debt constraints in a life-cycle model with an application to social security. J. Econ. Dyn. Control 32(12), 3745–3759 (2008)Google Scholar
  4. Araujo, A.P., Páscoa, M.R.: Bancruptcy in a model of unsecured claims. Econ. Theory 20(3), 455–481 (2002)Google Scholar
  5. Araujo, A., Monteiro, P., Páscoa, M.: Incomplete markets, continuum of states and default. Econ. Theory 11(1), 205–213 (1998)Google Scholar
  6. Arellano, C.: Default risk and income fluctuations in emerging economies. Am. Econ. Rev. 98(3), 690–712 (2008)Google Scholar
  7. Arellano, C., Mateos-Planas, X., Ríos-Rull J.V.: Partial Default. Manuscript (2013)Google Scholar
  8. Athreya, K., Tam, X., Young, E.: Unsecured credit markets are not insurance markets. J. Monet. Econ. 56(1), 83–103 (2009)Google Scholar
  9. Benjamin, D., Mateos-Planas, X.: Formal Versus Informal Default in Consumer Credit. Manuscript (2012)Google Scholar
  10. Benjamin, D., Wright, M.: Recovery Before Redemption: A Theory of Delays in Sovereign Debt Renegotiations, Working Paper (2009)Google Scholar
  11. Broer, T.: The Wrong Shape of Insurance? What Cross-Sectional Distributions Tell Us About Models of Consumption-Smoothing, CEPR Discussion Paper No. DP8701 (2011)Google Scholar
  12. Chatterjee, S.: An equilibrium model of the timing of bankruptcy filings. Presented at Credit, Default and Bankruptcy Conference, LAEF, UCSB (2010)Google Scholar
  13. Chatterjee, S., Eyigungor, B.: Maturity, indebtedness, and default risk. Am. Econ. Rev. 102(6), 2674–99 (2012)Google Scholar
  14. Chatterjee, S., Corbae, D., Nakajima, M., Ríos-Rull, J.: A quantitative theory of unsecured consumer credit with risk of default. Econometrica 75(6), 1525–1589 (2007)Google Scholar
  15. Cordoba, J.: US inequality: debt constraints or incomplete asset markets? J. Monet. Econ. 55(2), 350–364 (2008)Google Scholar
  16. Dawsey, A., Ausubel, L.: Informal Bankruptcy, unpublished (2004)Google Scholar
  17. Dawsey, A., Hynes, R., Ausubel, L.: The Regulation of Non-judicial Debt Collection and the Consumer’s Choice Among Repayment, Bankruptcy and Informal Bankruptcy, University of Virginia Legal Working Paper Series, p. 42 (2008)Google Scholar
  18. Diamond, D.W.: Financial intermediation and delegated monitoring. Rev. Econ. Stud. 51(3), 393–414 (1984)Google Scholar
  19. Díaz-Giménez, J., Glover, A., Ríos-Rull, J.: Facts on the distributions of earnings, income, and wealth in the United States: 2007 update. Fed. Reserve Bank Minneap. Q. Rev. 34(1), 2–31 (2011)Google Scholar
  20. Dubey, P., Geanakoplos, J., Shubik, M.: Default and punishment in general equilibrium1. Econometrica 73(1), 1–37 (2005)Google Scholar
  21. Eaton, J., Gersovitz, M.: Debt with potential repudiation: theoretical and empirical analysis. Rev. Econ. Stud. 48(2), 289–309 (1981)Google Scholar
  22. Fernandez-Villaverde, J., Krueger, D.: Consumption and saving over the life cycle: how important are consumer durables? Macroecon. Dyn. 15(5), 725 (2011)Google Scholar
  23. Heathcote, J., Storesletten, K., Violante, G.L.: The macroeconomic implications of rising wage inequality in the United States. J. Polit. Econ. 118(4), 681–722 (2010)Google Scholar
  24. Herkenhoff, K.: Informal Unemployment Insurance and Labor Market Dynamics. FRB of St, Louis Working Paper No (2012)Google Scholar
  25. Kaplan, G., Violante, G.: How much consumption insurance beyond self insurance? Am. Econ. J.: Macroecon. 38(2), 53–87 (2010)Google Scholar
  26. Kehoe, T., Levine, D.: Debt-constrained asset markets. Rev. Econ. Stud. 60(4), 865–888 (1993)Google Scholar
  27. Kehoe, T., Levine, D.: Liquidity constrained markets versus debt constrained markets. Econometrica 69(3), 575–598 (2001)Google Scholar
  28. Kehoe, T., Levine, D.: Bankruptcy and Collateral in Debt Constrained Markets, NBER Working Paper (2006)Google Scholar
  29. Kehoe, P., Perri, F.: International business cycles with endogenous incomplete markets. Econometrica 70(3), 907–928 (2002)Google Scholar
  30. Kilenthong, W.T.: Collateral premia and risk sharing under limited commitment. Econ. Theory 46(3), 475–501 (2011)Google Scholar
  31. Koeppl, T.V.: Optimal dynamic risk sharing when enforcement is a decision variable. J. Econ. Theory 134(1), 34–60 (2007)Google Scholar
  32. Krueger, D., Perri, F.: Does income inequality lead to consumption inequality? Evidence and theory1. Rev. Econ. Stud. 73(1), 163–193 (2006)Google Scholar
  33. Livshits, I., MacGee, J., Tertilt, M.: Consumer bankruptcy: a fresh start. Am. Econ. Rev. 97(1), 402–418 (2007)Google Scholar
  34. Livshits, I., MacGee, J., Tertilt, M.: Accounting for the rise in consumer bankruptcies. Am. Econ. J. Macroecon. 2(2), 165–193 (2010)Google Scholar
  35. Mateos-Planas, X.: Credit limits and bankruptcy. Econ. Lett. 121(3), 469–472 (2013)Google Scholar
  36. Mateos-Planas, X., Ríos-Rull, J.V.: Credit Lines, Manuscript (2013)Google Scholar
  37. Mateos-Planas, X., Seccia, G.: Welfare implications of endogenous credit limits with bankruptcy. J. Econ. Dyn. Control 30(11), 2081–2115 (2006)Google Scholar
  38. Peiris, M.U., Vardoulakis, A.P.: Savings and default. Econ. Theory 54(1), 1–28 (2011)Google Scholar
  39. Poblete-Cazenave, R., Torres-Martínez, J.P.: Equilibrium with limited-recourse collateralized loans. Econ. Theory 53(1), 1–31 (2010)Google Scholar
  40. Wang, M.: Optimal education policies under endogenous borrowing constraints. Econ. Theory, 1–25 (2011). doi:10.1007/s00199-013-0743-5
  41. Yue, V.: Sovereign default and debt renegotiation. J. Int. Econ. 80(2), 176–187 (2010)Google Scholar
  42. Zame, W.: Efficiency and the role of default when security markets are incomplete. Am. Econ. Rev. 83(5), 1142–1164 (1993)Google Scholar
  43. Zhang, H.: Endogenous borrowing constraints with incomplete markets. J. Financ. 52(5), 2187–2209 (1997)Google Scholar

Copyright information

© Springer-Verlag Berlin Heidelberg 2013

Authors and Affiliations

  1. 1.School of Economics and FinanceQueen Mary University of LondonLondonUK
  2. 2.Economics, Social SciencesUniversity of SouthamptonSouthamptonUK

Personalised recommendations