Cleansing by tight credit: Rational cycles and endogenous lending standards

Abstract

Endogenous cycles emerge through the two-way interaction between lending standards and production fundamentals. Lax lending standards in booms lead to low interest rates and high output but the deterioration of future loan quality. Low borrower quality in turn precipitates tight standards: the economy enters a recession with high credit spreads and low output 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. The capitalization of expert investors determines the strength of capital reallocation in recessions. Furthermore, although the constrained efficient economy is often cyclical, it features both a static and a dynamic externality in credit supply, hence differing from the decentralized equilibrium.