Credit Cycles and Business Cycles

Abstract

Unsecured firm credit moves procyclically in the United States and tends to lead gross domestic product, while secured firm credit is acyclical. Shocks to unsecured firm credit explain a far larger fraction of output fluctuations than shocks to secured credit. This article surveys a tractable dynamic general equilibrium model in which constraints on unsecured firm credit preclude an efficient capital allocation among heterogeneous firms. Unsecured credit rests on the value that borrowers attach to a good credit reputation, which is a forward-looking variable. Self-fulfilling beliefs over future credit conditions naturally generate endogenously persistent business cycle dynamics. A dynamic complementarity between current and future borrowing limits permits uncorrelated belief shocks to unsecured debt to trigger persistent aggregate fluctuations in both secured and unsecured debt, factor productivity, and output. The author shows that these sunspot shocks are quantitatively important, accounting for around half of output volatility.