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201305Endogenous Credit Cycles.pdf
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Endogenous Credit Cycles
∗
Alberto Martin
†
CREI and Universitat Pompeu Fabra
First version: November 2004
Revised: August 2008
Abstract
I develop an overlapping-generations framework in which changes in lending standards gen-
erate endogenous cycles. In my economy, entrepreneurs who are privately informed about the
quality of their projects need to borrow funds. Intermediaries screen entrepreneurs both through
the amount of investment undertaken and through the level of entrepreneurial net worth.
I show that endogenous regime switches in financial contracts —from pooling to separating
and vice-versa— may generate fluctuations even in the absence of exogenous shocks. When
the economy is in the pooling (separating) regime, lending standards seem “lax” (“tight”) and
investment is high (low). Differently from the existing literature, my model does not require
entrepreneurial net worth to be counter cyclycal or inconsequential for determining aggregate
investment.
Keywords: Adverse Selection, Cycles, Endogenous Fluctuations, Lending Standards, Screen-
ing
∗
I am deeply indebted to Paolo Siconolfi for constant encouragement. I am particularly grateful to John Geanako-
plos, John Donaldson, Pietro Reichlin and Tano Santos for discussions and important insights. I also thank Max
Amarante, Dirk Bergemann, Alex Citanna, Bruce Preston, Bernard Salanie, Guido Sandleris, Filippo Taddei, Wouter
Vergote and seminar participants at Columbia University, Harvard University (JFK), Universitat Pompeu Fabra, Uni-
versity of California at San Diego, University of Western Ontario, Yale University and at the IV Villa Mondragone
Workshop in Economic Theory and Econometrics.
†
Email: alberto.martin@upf.edu
1 Introduction
Over the past two decades, a substantial body of research has sought to study the relationship
between financial markets and macroeconomic fluctuations. Although encompassing a variety of
different perspectives, this research has almost exclusively focused on the channels through which
the financial system may amplify the effect of exogenous shocks. By focusing on the particular role
of the financial system as an amplifier, this literature has been unable to account for a commonly
expressed view among economists and policy makers: namely, that periods characterized by lax
credit and rapid expansion of output and investment may themselves sow the seeds of a future
downturn.
The goal of this paper is to provide a stylized model in which, absent any type of shocks,
imperfections in financial markets are themselves a source of macroeconomic fluctuations. I study
an overlapping-generations economy in which credit markets are characterized by the presence of
adverse selection. Differently from the existing literature, my environment can be consistent with
two widely accepted empirical regularities: greater net worth of borrowers leads on average to
greater investment, and net worth is pro-cyclical. My main result is that, despite the absence
of exogenous shocks, the economy can exhibit fluctuations that are purely generated by changes
in lending standards. More precisely, the economy may exhibit periods of expansion in credit,
investment, and entrepreneurial net worth that are followed by downturns in which investment,
output, and entrepreneurial net worth contract.
In my economy, each generation is composed of households and entrepreneurs. Entrepreneurs
need to borrow in order to finance their investment opportunities, regarding which they possess
private information. Financial intermediaries seek to mitigate the asymmetry of information by
offering a menu of contracts. In particular, financial intermediaries try to screen entrepreneurs
through the amounts of collateral that they provide and of investment that they undertake. De-
pending on the level of entrepreneurial wealth, the credit market equilibrium may either entail
pooling, so that all entrepreneurs borrow indistinctly at the same terms, or separation, so that
different entrepreneurs borrow at different rates of collateralization, pay different rates of interest,
and undertake different levels of investment. It is precisely these switches of regime, from pooling
to separation and vice-versa, which may generate aggregate fluctuations even in the absence of
exogenous perturbations.
When entrepreneurial wealth is low, screening is relatively costly in my economy since it must
be predominantly done by restricting the amount of investment undertaken by good entrepreneurs.
Hence, there is a strong tendency to pool all projects and have good entrepreneurs cross-subsidize
1
their bad counterparts. Whereas cross-subsidization implies that the pooling equilibrium is costly
for good entrepreneurs, it also benefits them by allowing them to expand their investment. If the
average quality of investment in the economy is above a certain threshold, pooling contracts yield
a relatively high level of investment, future output and —more specifically— future entrepreneurial
wealth.
As entrepreneurial wealth increases, though, the screening possibilities of intermediaries are
enhanced, since they can increasingly screen through collateralization requirements. Eventually,
intermediaries are able to design profitable contracts tailored to attract the most productive entre-
preneurs from the pool. In this way, there is a “flight of quality” phenomenon by which the best
entrepreneurs are lured away from the pooling equilibrium, which unravels into a separating regime
and —in so doing— leads to a decrease in investment, future output, and future entrepreneurial net
worth. Why does investment fall when the economy switches from a pooling to a separating regime?
The investment of bad entrepreneurs must surely fall in this case, since they overinvest in the pool-
ing equilibrium. As for good entrepreneurs, they must also decrease their level of investment: by
definition, these entrepreneurs are indifferent between the pooling and the separating regimes at the
switching point. But it is cheaper for them to borrow through separating contracts, because these
contracts do not entail cross-subsidization. Hence, the only way in which good entrepreneurs can
be indifferent between both regimes is if the separating contracts entail a lower level of investment
than the pooling contracts do. When the economy switches from a pooling to a separating regime,
then, investment and future output fall: if this fall is sufficiently large, the economy may revert to
a pooling equilibrium and the process starts again.
It must be stressed that fluctuations in my setting are deterministic and arise in a fully ratio-
nal environment. Evidently, this is in contrast to views by which fluctuations or instability are
generated by some form of irrational behavior, as in the Keynesian concept of “animal spirits” or
Kindleberger’s (1996) account of financial crises. It is interesting to note, however, that due to
the pro-cyclicality of net worth, fluctuations in my economy could be observationally equivalent
to some form of irrationality: an outside observer would see investment decrease in a context of
increasing output and net worth and in the absence of any exogenous shock. In my model, though,
regime switches between pooling and separating contracts may induce rational entrepreneurs to
contract investment even as net worth increases.
Although the main objective of this paper is conceptual in nature, the mechanism behind
endogenous fluctuations in my model is consistent with different strands of stylized evidence. In the
first place, booms may revert into recessions in my framework even if entrepreneurial wealth is pro-
cyclical and investment is on average increasing in net worth, both features that seem consistent with
2
empirical evidence.
1
This is in contrast with previous models dealing with endogenous reversion
mechanisms in the presence of financial frictions, which require net worth to be either counter-
cyclical or inconsequential for the allocation of credit.
An additional feature of my model that is consistent with stylized evidence is that my endoge-
nous reversion mechanism is driven by changes in lending standards. For a long time, both policy
makers and bankers have expressed the view that changes in bank lending standards play a crucial
role in macroeconomic fluctuations,
2
and empirical studies tend to confirm this view. Although
mostly interested in business cycle dynamics, the studies by Asea and Blomberg (1998) and Lown
and Morgan (2006) document that bank lending standards in the United States change over the
cycle and seem to have a significant effect on the dynamics of the latter. The former study, in
particular, finds that “during booms asymmetric information in credit markets may cause good
projects to draw in bad ones”, generating “the opposite of Akerlof’s celebrated Lemon’s principle.”
This is consistent with the mechanism in my model, by which lending booms are possible insofar
good projects cross-subsidize their bad counterparts.
1.1 Related Literature
This paper is related to different strands of literature. The modeling of adverse selection in credit
markets is based on Martin (2008), which is in turn related to the work by Bester (1985, 1987), De
Meza and Webb (1987), and Besanko and Thakor (1987). The crucial role played by the relationship
between the net worth of borrowers and aggregate investment also relates this paper to Bernanke
and Gertler (1989) and Kiyotaki and Moore (1997). Both of these papers rest on the notion that,
in the presence of asymmetric information regarding borrowers, loan contracts will entail the use
of collateral and credit rationing. Thus, to the extent that net worth is pro-cyclical, shocks to the
economy have a direct impact on the balance sheets of borrowers, thereby affecting the degree to
which borrowing is constrained and the aggregate level of investment.
Recent work has analyzed mechanisms through which asymmetric information in credit markets
may not just lead to the amplification of exogenous shocks, but may itself be a source of endogenous
fluctuations. The papers by Suarez and Sussman (1997), Azariadis and Smith (1993), and Reichlin
and Siconolfi (2004) fall within this category. In all of these models, though, fluctuations rely
either on generating counter-cyclical dynamics for entrepreneurial net worth or on assuming that
the latter plays no role in determining the equilibrium level of investment.
In the paper by Suarez and Sussman (1997), the emergence of endogenous cycles requires net
1
For evidence of procyclicality on profit margins and cash flows in UK manufacturing see Small (1997, 2000). For
a survey on the evidence regarding the impact of net worth on investment, see Hubbard (1998).
2
See, for example, Weinberg (1995).
3
worth to be counter-cyclical: when output is high, the relative price of the good produced by
entrepreneurs falls and —along with it— so does their net worth in terms of inputs.
3
As Reichlin
(2004) notes, however, net worth is thought to be pro-cyclical and empirical evidence on asset prices,
profit margins, and cash flows supports this notion. In the papers by Azariadis and Smith (1993)
and Reichlin and Siconolfi (2004), on the other hand, entrepreneurs either have no endowment or
it plays no role in determining the allocation of credit. Once again, this is at odds with empirical
findings by which investment seems to be significantly affected by firms’ net worth.
Two exceptions to the previous observations are Matsuyama (2007) and Figueroa and Leukhina
(2008). Matsuyama (2007) studies an OLG economy in which credit-constrained entrepreneurs may
chose to undertake different investment projects. One type of project yields a high return that is
difficult to pledge, whereas another yields a low return that is highly pledgeable. When the net
worth of entrepreneurs is very low, credit constraints tend to bind regardless of the type of project
that is chosen: hence, entrepreneurs chose the high-return project. As the economy grows and
net worth increases, though, the credit constraint ceases to bind first for the low-return project.
For some parameter configurations, this might lead all entrepreneurs to undertake the low-return
project when a certain level of net worth is reached, thereby generating a decrease in future output
and net worth and possibly giving rise to endogenous fluctuations. As in my framework, then,
the source of fluctuations in Matsuyama is the changing composition of investment. Differently
from Matsuyama, though, the composition of investment in my economy varies not because of
differences in the pledgeability of output across different technologies, but because of changes
in lending standards brought about by competition among lenders. More recently, Figueroa and
Leukhina (2008) develop a model in which —similarly to this paper— regime switches between pooling
and separating equilibria give rise to endogenous fluctuations.
To conclude, I believe that the mechanism behind endogenous fluctuations in my framework
arises naturally in a standard setting of adverse selection. Besides the aforementioned considerations
regarding net worth, it is also the case that my mechanism does not rely on particular relative price
changes or on assumptions regarding the mix of adverse selection and moral hazard. There are
many similarities between my model and that of Reichlin and Siconolfi (2004), for example: the
latter, however, relies on a particular mix between these two types of asymmetric information,
which ultimately makes it difficult to identify the underlying assumptions that generate different
effects. In this sense, my framework complements the existing literature by highlighting a new
reversion mechanism that arises in the presence of adverse selection.
3
Although very different in its objective, the model by Aghion, Bacchetta and Banerjee (2004) relies on a similar
mechanism.
4
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