Bankruptcy, Liquidity, and Recession
By BEN S. BERNANKE
This paper examines the possibility that the economy-wide level of bankruptcy risk plays a structural role in the propagation of recessions. The argument is as follows: Bankruptcy imposes net social costs, so that all agents have an interest in avoiding it. Consumers and firms do this by being careful to retain sufficient liquid assets to meet fixed expenses; banks and other lenders, by being selective in choosing borrowers and limiting the size of loans. The onset of recession strains the system by reducing the flow of income available to meet current obligations and by increasing uncertainty about future liquidity needs. There is a general attempt to insure solvency which leads to a reduced demand for consumer and producer durables-which may in turn generate further income reductions. I find that this story helps explain some features of recession. It is largely but not entirely supported by the available evidence.
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