“Financial Innovation, Collateral, and Investment,” article by Ana Fostel and John Geanakoplos in American Economic Journal: Macroeconomics (2015)
Financial innovations that change how promises are collateralized affect prices and investment, even in the absence of any change in fundamentals. In C-models, the ability to leverage an asset always generates overinvestment compared to Arrow-Debreu. Credit Default Swaps always leads to underinvestment with respect to Arrow-Debreu, and in some cases even robustly destroy competitive equilibrium. The need for collateral would seem to cause underinvestment. This analysis illustrates a countervailing force: goods that serve as collateral yield additional services and can therefore be over-valued and over-produced. In models without cash flow problems there is never marginal underinvestment on collateral.