- Regulation is about aligning private and social trade-offs.
- When banks cause negative externalities, good regulatory interventions increase banks’ costs.
- Externalities may differ across countries, so nothing suggests that regulation induced costs should be the same internationally.
In Econometrica, Emmanuel Farhi and Iván Werning neatly summarize how their work on demand externalities fits in the literature.
… pecuniary externalities, which were first shown to arise when a simple friction, market incompleteness, is introduced into the Arrow–Debreu framework (see, e.g., Hart (1975), Stiglitz (1982), Geanakoplos and Polemarchakis (1985), Geanakoplos, Magill, Quinzii, and Dreze (1990)). The logic is as follows. When asset markets are incomplete and there is more than one commodity, a redistribution of asset holdings generically induces relative price changes in spot markets, in each state of the world. These relative price changes, in turn, affect the spanning properties of the limited assets that are available, potentially improving insurance. Such a pecuniary externality is not internalized by private agents. As a result, the equilibrium is generically constrained inefficient: it can be improved upon by interventions in the existing financial markets. Similar results obtain in economies with borrowing constraints that depend on prices of goods and assets, or when contracting is constrained by private information (see, e.g., Greenwald and Stiglitz (1986)). … [Other work in this literature includes Caballero and Krishnamurthy (2001), Lorenzoni (2008), Farhi, Golosov, and Tsyvinski (2009), Bianchi and Mendoza (2010), Jeanne and Korinek (2010), Bianchi (2011), Korinek (2011), Davilla (2011), Stein (2012), Korinek (2012a, 2012b), Jeanne and Korinek (2013), Woodford (2011).]
… Instead of pecuniary externalities, our theory emphasizes aggregate demand externalities. In addition to providing a new foundation for macroprudential policies, our framework, focusing on monetary policy and nominal rigidities, is well posed for the joint study of monetary and macroprudential policy.
… using a perturbation argument similar in spirit to that in Geanakoplos and Polemarchakis (1985), we show that equilibria that are not first best can be improved upon by interventions in financial markets, except in non-generic knife-edge cases. … In [the pecuniary externality] literature, the key frictions lie in financial markets themselves; in our baseline model, we assume complete markets. Pecuniary externalities rely on price movements; in our framework, price rigidities tend to negate such effects. Our results are instead driven by aggregate demand externalities that arise from nominal rigidities.
Review of Economic Dynamics 18(4), October 2015, with Martín Gonzalez-Eiras. PDF.
Traditional “economic equivalence” results, like the Ricardian equivalence proposition, define equivalence classes over exogenous policies. We derive “politico-economic equivalence” conditions that apply in environments where policy is endogenous and chosen sequentially. A policy regime and a state are equivalent to another such pair if both pairs give rise to the same allocation in politico-economic equilibrium. The equivalence conditions help to identify factors that render institutional change non-neutral and to construct politico-economic equilibria in new policy regimes. We exemplify their use in the context of several applications, relating to social security reform, tax-smoothing policies and measures to correct externalities.