Macroeconomic Dynamics of Assets, Leverage and Trust

Abstract

A macroeconomic model based on the economic variables (i) assets, (ii) leverage (defined as debt over asset) and (iii) trust (defined as the maximum sustainable leverage) is proposed to investigate the role of credit in the dynamics of economic growth, and how credit may be associated with both economic performance and confidence. Our first notable finding is the mechanism of reward/penalty associated with patience, as quantified by the return on assets. In regular economies where the EBITA/Assets ratio is larger than the cost of debt, starting with a trust higher than leverage results in the highest long-term return on assets (which can be seen as a proxy for economic growth). Our second main finding concerns a recommendation for the reaction of a central bank to an external shock that affects negatively the economic growth. We find that late policy intervention in the model economy results in the highest long-term return on assets and largest asset value. But this comes at the cost of suffering longer from the crisis until the intervention occurs. The phenomenon can be ascribed to the fact that postponing intervention allows trust to increase first, and it is most effective to intervene when trust is high. These results derive from two fundamental assumptions underlying our model: (a) trust tends to increase when it is above leverage; (b) economic agents learn optimally to adjust debt for a given level of trust and amount of assets. Using a Markov Switching Model for the EBITA/Assets ratio, we have successfully calibrated our model to the empirical data of the return on equity of the EURO STOXX 50 for the time period 2000-2013. We find that dynamics of leverage and trust can be highly non-monotonous with curved trajectories, as a result of the nonlinear coupling between the variables.