The Liquidity Approach to Bubbles, Crises, Jobless Recoveries, and Involuntary Unemployment

Abstract

The paper shows that liquidity considerations provide a simple rationale for the creation and destruction of bubbles, and related disturbances in the credit market—the fall in collateral values, in particular. It presents a framework in which credit disturbances can explain jobless recoveries and involuntary unemployment. Jobless recovery follows from the assumption that job creation is at a disadvantage with respect to physical capital investment projects, because the latter furnish their own collateral. Involuntary unemployment arises because, due to severe working capital constraints, the full-employment real wage would ravage work ethic to such an extent that firms find it more profitable setting their wages above the full-employment level—even though nominal wages are perfectly downward flexible. The models are simple and intuitive, and provide an alternative approach which the paper claims is well suited for understanding some basic and common features of financial crises.