Fire-Sale Externalities

This paper characterizes the efficiency properties of competitive economies with financial constraints and fire sales. It shows that two distinct pecuniary externalities occur in such settings: distributive externalities that arise from incomplete insurance markets and can take any sign; and collateral externalities that arise from price-dependent financial constraints and are conducive to over-borrowing. For both types of externalities, it identifies three sufficient statistics that determine optimal taxes on financing and investment decisions to implement constrained efficient allocations. It illustrates how to employ our framework in a number of applications. It highlights how small changes in parameters may cause the sufficient statistics that drive distributive externalities to flip sign, either leading to under- or over-borrowing. It also shows that financial amplification is neither necessary nor sufficient to generate inefficient fire-sale externalities. [Working Paper 22444]