What is the main limitation of much modern macroeconomic theory, among the failings pointed out by William R. White at the 2010 Mayekawa Lecture? We argue that the main deﬁciency is a failure to incorporate the possibility of default, including that of banks, into the core of the analysis. With default assumed away, there can be no role for ﬁnancial intermediaries, for ﬁnancial disturbances, or even for money. Models incorporating defaults are, however, harder to construct, in part because the representative agent ﬁction must be abandoned. Moreover, ﬁnancial crises are hard to predict and to resolve. All of the previously available alternatives for handling failing systemically important ﬁnancial institutions (SIFIs) are problematical. We end by discussing a variety of current proposals for improving the resolution of failed SIFIs.
Keywords: Default; Transversality; Money; Bankruptcy cost; Asset bubbles; Resolution mechanisms
Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.