Peter Kondor (London School of Economics and CEPR)

Cleansing by Tight Credit: Rational Cycles and Endogenous Lending Standards

Joint with Maryam Farboodi (MIT, NBER & CEPR)

Abstract. Endogenous cycles emerge through the two-way interaction between lending standards 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. As such, credit standards play a dual role. If they help the economy through promoting loan quantity today, they hurt future loan quality, and vice-versa. Investors don’t internalize either role, thus, the constraint efficient economy features both a static and a dynamic externality, and albeit often being cyclical, it differs from the decentralized equilibrium.