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By Jeffrey Ely

We are all macroeconomists, now that Roger Myerson is one. Today at Northwestern he presented his new work on A Moral Hazard Model of Credit Cycles. It attracted a huge crowd, not surprisingly, and introduced a whole new class of economists to the joy and sweat of a Roger Myerson lecture.

(Roger apparently hasn’t read my advice for giving talks.) Listening to Roger speak is not only thoroughly enlightening and entertaining, its calisthenics for the mind. I once brought a pen and pad to one of his talks and outlined his nested digressions. It is absolutely a thing of beauty when every step down the indentation ladder is paired with a matching step on the way back up. When he finally returns to the original stepping off point, no threads are left hanging.

Keeping track of all this in your head and still following the thread of the talk is a bit like Lucy and Ethel wrapping candy.
Still, I think I got the basic point. Roger has a model of credit cycles that falls out naturally from a well-known feature of dynamic moral hazard. In his model, banks are intermediaries between investors and entreprenuers and they are incentivized via huge bonuses to invest efficiently. These bonuses are paid only when the bankers retire with a record of success.

These backloaded incentives mean that bankers are trusted with bigger funds the closer they are to retirement. That’s when the coming payout looms largest, deterring bankers from diverting the larger sums for their own benefit. Credit cycles are an immediate result. Because bankers handle larger sums near their retirement than those just starting out, their retirement means that total investment must go down. So the business cycle tracks the age demographics of the banking sector.

(It’s the Cocoon theory of business cycles, because if you could extend the lives of bankers you would enhance the power of incentives, lowering the moral hazard rents and increasing investment.)

Source: Backloaded Banking Incentives and Macroeconomics