Macroeconomic implications of limited enforcement in closed and open economies

University Of Southern California, Los Angeles CA

Investigators

Abstract

The current and future research described in this proposal is directed toward understanding the link between the limited enforcement of contracts and the macro performance in closed and open economies. The proposal encompasses three sub-projects each studying the role of limited enforcement but for different macroeconomic issues. The first sub-project investigates the adoption of advanced technologies and innovation. A distinguished feature of modern technologies, such as, information and communication technologies, biotechnologies and nanotechnologies, is the importance of skilled human capital or knowledge. The ability of a society to innovate and grow is dependent on how human capital is accumulated and organized and how the returns are shared among the participants in the innovation process. These depend on the types of contractual arrangements that are feasible or enforceable to provide the right incentives. The goal of this part of the project is to study how free entry (competition) affects the accumulation of innovation skills and the growth of the economy when contracts are not perfectly enforceable. Whether free entry enhances innovation has been a major topic of research and debate since Schumpeter's claim that, while product market competition could be detrimental for innovations, competition in the innovation sector encourages innovations. Most of the subsequent literature has focused on market structure and product market competition and, in particular, on the ability to gain market shares and appropriate the returns to R&D. In contrast to the existing literature, this project will focus on the less studied dimension of 'human capital' competition that is created by free entry. It is the presence of limited enforcement of contracts that makes 'competition for human capital' essential for growth. The second sub-project investigates whether the lower macroeconomic volatility observed in the United States during the last two decades is, at least in part, the consequence of financial markets innovations that alleviate the macroeconomic consequences of limited enforcement of (debt) contracts. The project is motivated by some stylized facts about the dynamics of the financial structure of firms which has changed dramatically during the last twenty years. First, the business sector has become more leveraged and the debt exposure has become more volatile. Second, the volatility of new equity issues has increased during the last two decades. These findings suggest that firms have become more flexible in the choice of their financial structure. The project investigates the extent to which this greater flexibility can account for the decline in the observed macroeconomic volatility. The third sub-project investigates the causes of the recent imbalances in the international context characterized by growing foreign assets liabilities in some countries and the accumulation of positive foreign asset positions in other countries. The goal is to study the extent to which these imbalances arise naturally as a consequence of international capital markets liberalization when countries are heterogeneous in the degree of domestic financial development. The project is motivated by the observation that the major countries with growing foreign asset liabilities are those with more advanced financial markets. To address this question the project develops a multi-country model with uninsurable idiosyncratic risks. Market incompleteness is derived endogenously through the limited enforceability of contracts. Differences in cross-country financial development are captured by differences in contracts enforcement. The three sub-projects are linked by a common denominator, that is, by the importance of endogenous market incompleteness in the form of limited contract enforcement. They provide a better understanding of the factors that generate cross-country income inequality and growth, the reduced business cycle volatility, and the growing imbalances in the globalized economy. The full understanding of these issues is crucial for the design of policy interventions including policies directed at liberalizing the international mobility of capital.