currency depreciation and severe real contraction that struck such economies as Indonesia in 1998 andArgentina in 2002 – are largely the result of private-sector indebtedness in foreign currency. Suchindebtedness, it is argued, exposes economies to a vicious circle closely related to Fisherian debtdeflation: a falling currency causes the domestic-currency value of debts to soar, leading to economicweakness that in turn causes further depreciation.Given both the prominence of debt in popular discussion of our current economic difficulties and thelong tradition of invoking debt as a key factor in major economic contractions, one might have expecteddebt to be at the heart of most mainstream macroeconomic models– especially the analysis of monetaryand fiscal policy. Perhaps somewhat surprisingly, however, it is quite common to abstract altogether from this feature of the economy.
Even economists trying to analyze the problems of monetary andfiscal policy at the zero lower bound – and yes, that includes the authors (see e.g. Krugman 1998,Eggertsson and Woodford 2003) -- have often adopted representative-agent models in which everyone isalike, and in which the shock that pushes the economy into a situation in which even a zero interest rateis not low enough takes the form of a shift in everyone’s preferences. Now, this assumed preferenceshift can be viewed as a proxy for a more realistic but harder-to-model shock involving debt and forceddeleveraging. But as we will see, a model that is explicit about the distinction between debtors andcreditors is much more useful than a representative-agent model when it comes to making sense of current policy debates.Consider, for example, the anti-fiscal policy argument we have already mentioned, which is that youcannot cure a problem created by too much debt by piling on even more debt. Households borrowed toomuch, say many people; now you want the government to borrow even more?