The most influential New Classical and New Keynesian theorists all worked in what economists call a ‘complete markets paradigm’. In a world where there are markets for contingent claims trading that span all possible states of nature (all possible contingencies and outcomes), and in which intertemporal budget constraints are always satisfied by assumption, default, bankruptcy and insolvency are impossible. As a result, illiquidity – both funding illiquidity and market illiquidity – are also impossible, unless the guilt-ridden economic theorist imposes some unnatural (given the structure of the models he is working with), arbitrary friction(s), that made something called ‘money’ more liquid than everything else, but for no good reason. The irony of modelling liquidity by imposing money as a constraint on trade was lost on the profession.
Both the New Classical and New Keynesian complete markets macroeconomic theories not only did not allow questions about insolvency and illiquidity to be answered. They did not allow such questions to be asked.
[H/t: Mark Blyth]