Cleansing by Tight Credit: Rational Cycles and Endogenous Lending Standards

From Maryam Farboodi and Péter Kondor

Endogenous cycles emerge through the two-way interaction between lenders’ behavior in the credit market and production fundamentals. When lenders choose credit quantity over quality, the resulting lax lending standards lead to low interest rates and high output growth but the deterioration of future loan quality. When the quality is sufficiently low, lenders switch to tight standards, causing high credit spreads and low growth but a gradual improvement in the quality of loans. This eventually triggers a shift back to a boom with lax lending, and the cycle continues. Thus, the tight lending standards play a dual role: On one hand, they stifle contemporaneous lending and dampen concurrent productive investment. On the other hand, they cleanse the economy of low quality borrowers and lead to healthier subsequent booms. Neither of these forces are internalized by lenders. We show that the constraint efficient economy, albeit being often cyclical, differs from the decentralized equilibrium