Credit Externalities: Macroeconomic Effects and Policy Implications

Abstract

Financial crises are often preceded by peri ods of credit expansion during which firms and households become increasingly vulnerable to a reversal in economic conditions. When eco nomic conditions actually worsen, financing constraints become tighter, causing a deeper contraction of economic activity. These events have led to policy proposals for preventing excessive borrowing during “normal times.” If rational agents evaluate financing decisions from a privately optimal standpoint, why would the debt level not be socially efficient? The theoretical literature has offered an answer to this question based on a pecuniary externality that arises due to the presence of financial frictions: private agents tend to under value net worth during a period of financial distress because they fail to internalize the fact that additional net worth would have positive spillovers on other agents’ balance sheets. 1 As a result, private agents borrow excessively. The quantitative implications of these “credit exter nalities,” however, remain largely unknown. In particular, these key questions have not been addressed: