"Intermediation Cost, Credit Expansion and Inequality" [download]

Over the past decades, there has been a dramatic credit boom in the United States, coupled with decreasing asset returns and rising inequality. This paper analyzes whether the decreasing intermediation cost of borrowing is an explanation for these developments. It first provides empirical evidence that the intermediation costs have decreased between 1980 and 2007. We then develop a dynamic general equilibrium model of heterogeneous investors and idiosyncratic investment risk. We find that the macroeconomic effects of the fall in intermediation costs are amplified by two feedback loops: one is between the capital market and the credit market, and another is between the capital-credit market and the wealth distribution. We show that, due to lower intermediation costs, the credit market experiences a "simultaneous" expansion of credit demand and credit supply. As a result, the real risk-free interest rate barely changes. The capital market also expands, leading to a decrease in the returns on capital. The feedback loops exaggerate the capital-income risk and increase the average returns on investment among leveraged investors, driving up the overall wealth and income inequality. In a quantitative exercise, we find that much of the rise in the top-end wealth inequality during 1980-2007 is explained by the reduction in the intermediation costs. In terms of welfare, we find that the welfare decreases for the households in the bottom-90% wealth group, while it improves for households in other groups.

"Sovereign Default, Taxation and the Underground Economy" (with Almuth Scholl) [download]

This paper studies the dynamic interaction between sovereign default risk, taxation, and the underground economy. For a large sample of countries, we find that the size of the underground economy is positively correlated with sovereign debt and interest spreads. We rationalize these empirical regularities within a quantitative model of sovereign default that explicitly accounts for underground activities. We highlight a vicious circle: Higher sovereign risk premia tighten the endogenous borrowing constraint and force the government to raise taxes. Tax hikes, however, induce the private sector to invest less and to evade taxes by producing in the underground sector. Eventually, falling tax revenues force the government to either implement further tax hikes or to default. Our quantitative findings suggest that the underground economy fosters sovereign default risk and deepens debt crises.