DEFAULT PENALTY AS A DISCIPLINARY AND SELECTION MECHANISM IN PRESENCE OF MULTIPLE EQUILIBRIA Shyam Sunder, Yale University (Joint work of Juergen Huber, Martin Shubik and Shyam Sunder) Experimental Economics and Finance 2010 The Wang Yanan Institute for Studies in Economics (WISE) Xiamen University, Xiamen, China December 15-16, 2010

2 A basic question and several solutions In the abstract general equilibrium theory of closed exchange and exchange-production economies, several equilibria may be present. Dynamic models of macro economy tend to ignore this possibility in spite of importance of reconciling theory and policy. Equilibrium selection has is a mathematical challenge Special solutions: existence of gross substitutability among all goods, or the presence of a good which appears as a linear separable term in all utility functions Perhaps enriching abstract models with politico- economic institutional features of the economy may be sufficient as first order approximations for equilibrium selection Candidates: combine fiat money with default and bankruptcy laws to create a synthetic commodity which appears as linear separable term in utilities Use a theoretically sufficient condition from institutional context to cut the Gordian knot of multiplicity of equilibria

3 A Summary of Experimental Evidence Default penalties and bankruptcy laws are needed to implement general equilibrium as a playable game and to mitigate strategic defaults They can also provide conditions for uniqueness of equilibria Assignment of default penalty on fiat money  economy goes to selected equilibrium Role of accounting/bankruptcy aspects of social mechanisms in resolving mathematically intractable multiplicity problem

4 The general equilibrium proof of the existence of a competitive price system was both a triumph and a disaster It provided a deep mathematization for the existence of equilibrium conditions for efficient prices that cut out time and uncertainty

5 A whole school of mathematical economics was born with considerable sophistication but little connection with the context and realities of the ongoing economy

6 The work of Arrow, Debreu and Mckenzie proved the existence of efficient prices but did nothing about their evolution or their fairness. This can be seen easily when we observe that an economy may have many equilibria.

7 One of the tasks of extreme mathematical difficulty is what necessary and sufficient conditions are required for a unique competitive equilibrium to exist? We suggest that the society addresses both uniqueness and fairness through its socio- economic institutions

8 We could explore this possibility by extending the model to embed it an a dynamic model of society that permits default and requires default laws. To this end, our program involves both theory and experimentation. We utilize an example of an exchange economy with three equilibrium points constructed by Shapley and Shubik This is illustrated in the next slide.

9 Figure 1: An Exchange Economy with Two Goods and Three Competitive Equilibria

10 We observe that it has three equilibrium points the two extreme ones favoring either traders of type a or b. The middle is more equitable (and is not stable under Walrasian dynamics)

11 When this exchange economy is remodeled as a playable strategic market game permitting borrowing, default rules must be specified to take care of every possibility in the system. But these rules will entail some action of negative worth to the defaulter and are denominated in money. Thus they link money to the individual’s utility

12 Technically if the penalties are set equal to or above the Lagrangian multipliers of the related general equilibrium model this will be sufficient to prevent strategic bankruptcy. Thus by selecting the penalties we can select the equilibrium point to be chosen.

13 In selecting the penalties associated with the middle equilibrium the society can resolves its “fairness” problem; but from the viewpoint of finance it does not select the minimal cash flow equilibrium. This is shown in the next slide

14 Comparison of Prices in the Three Competitive Equilibria Trade 1 Trade 2 Final 1Final 2Price 1 Price 2 Trade CE , , CE , , CE , ,

15 In higher dimensions it is always straightforward to select the minimum cash flow equilibrium, but this is not true for the selection of “fair” as well as efficient equilibrium In fact government selects the penalties more or less blindly and in the course of the application of legal and political pressures they are adjusted

16 There is a considerable literature on multiple equilibria as is summarized by Morris and shin(2000) They deal primarily with Bayesian equilibria with noise Our approach here is different from, but complementary with, this literature. We stress the laws of society as providing direct strong coordinating and coercive devices for the economy

17 Experimental Design and Results Balances Carried Forward Period to Period Endowments Refreshed each Period Exchange of Goods without Money T1a (A is numeraire), T1b (B is numeraire) Fail to converge to any CE Exchange of Goods with Money and Penalty Targeted at one of the CEs T2a, T2b, T2c Converge to selected CE T2a-R, T2b-R, T2c-R Converge to selected CE Exchange of Goods with Money and non-CE Penalty T3 Converge to other outcomes determined by selected penalty T3-R Converge to other outcomes determined by selected penalty

Treatment 1 Two subject types with endowments of (40, 0) and (0, 50) of goods (A, B). No money. All subjects know their initial endowments and the earnings functions, and bid and offer some of their endowments for exchange. Benchmark treatment to check the convergence in presence in theoretical multiplicity. 18

19 Treatment 1: Conjectures 1.In Treatment 1 the process fails to converge to any of the three competitive equilibria. 2.In Treatment 1 the middle CE is favored. 3.In Treatment 1 the choice of the medium of exchange or numeraire does not influence the outcomes (prices and distribution of goods).

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24 Treatment 1 No clear convergence to any of the three CEs. It does not matter which of the two goods in this exchange economy is chosen as the numeraire. Efficiency in all markets is high, demonstrating that such simple markets serve well as coordination mechanisms.

Treatment 2 Introduce money in endowment and and penalty for default Set mu(1) 1 and mu(2) = 0.28, 0.75 and 5.07 respectively, in Treatments 2a, 2b and 2c (corresponding to the respective marginal values of income in the three equilibria) Runs without and with reinitialization of endowments 25

26 Treatment 2: Conjectures 4. In Treatment 2 the system converges and can be made to converge to any of the three equilibria guided by the selection of parameter μ (default penalty). 5. In Treatment 2 net money holdings will be equal to the equilibrium level of zero.

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32 Treatment 2 These results of T2 and T2-R broadly confirm the results from T1—the introduction of a money allows convergence to the unique equilibrium that is defined by the value/default penalty associated with the money.

33 Treatment 3: Conjectures 6. In Treatment 3 the unique equilibrium defined by the default penalties μ1 and μ2 is approached.

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37 Treatment 3 The unique equilibrium defined by the chosen penalty is approached in Treatment 3.

38 Conclusions Attempt to explore the role of institutions (e.g., bankruptcy laws, accounting) in resolving multiplicity problems in closed economies Treatment 1 as a benchmark: Empirical support for theoretical indeterminacy. Treatment 2: Salvage value/default penalty of a fiat money can be chosen to achieve any of the competitive equilibria of the original economy. Treatment 3 as robustness check: Other penalties generate specific equilibrium outcomes (but not necessarily economize on use of money) Institutional arrangements in a society provide the means to resolve the possibility of multiple equilibria in an economy. Empirical support for the attitudes of macroeconomists who do not regard the non-uniqueness of competitive equilibria as a major applied problem.

39 Trading Screen without Fiat Money

40 Results Screen without Fiat Money

41 Payoff Tables

42 Trading Screen with Fiat Money

43 Results Screen with Fiat Money

44 Payoff Table with Fiat Money (T2c)

Thank You.