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Fragile New Economy: The Rise of Intangible Capital and Financial Instability

Author

Listed:
  • Ye Li

    (The Ohio State University)

Abstract
This paper studies financial instability in an economy where growth is driven by intangible investment. Firms' intangible investment creates new productive capital. Once created, capital can be sold to financial intermediaries. Since intangible investment is not pledgeable, firms carry cash, which is inside money issued by intermediaries (short-term safe debt). In good times, well capitalized intermediaries push up the price of capital. This motivates firms to create more capital, but to do so, they must build up cash holdings. As firms' money demand expands, the yield on inside money (i.e., intermediaries' debt cost) declines, so intermediaries increase leverage and push up capital price even further. This inside money channel generates several features shared with the U.S. economy before the Great Recession: rising corporate cash holdings, financial intermediaries growing through leverage, increasing asset prices, and declining interest rate. The model also generates endogenous risk accumulation: a longer period of boom and expansion of the financial sector predict a more severe crisis. In crises, the spiral flips, leading to sudden deleveraging of intermediaries, asset price collapse, and investment contraction.

Suggested Citation

  • Ye Li, 2018. "Fragile New Economy: The Rise of Intangible Capital and Financial Instability," 2018 Meeting Papers 1189, Society for Economic Dynamics.
    • Handle: RePEc:red:sed018:1189
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