Starting with the seminal contributions of Bernanke and Gertler (1989) and Kiyotaki and Moore (1997), a large theoretical literature in macroeconomics has studied the implications of credit market imperfections for investment and output dynamics. At the heart of this literature is the inverse relationship between firms’ financial assets, or equivalently internal funds, and the agency costs of investment. When asymmetric information or moral hazard problems entail agency costs in lending relationships, firms’ debt capacity is constrained by the level of assets that can be pledged to outside lenders.
An adverse shock that worsen financial conditions may therefore generate a negative spiral, where low profits reduce debt capacity and hence investment, which further reduces profit, amplifying the initial negative shock, and so forth. This amplification mechanism, known as the credit multiplier or the financial accelerator, has been extremely influential in explaining how relatively small and temporary exogenous shocks to the economy may be amplified and become persistent.
A salient feature of models featuring a credit multiplier is that agency costs are more severe in recessions than in booms, precisely because agency costs are inversely related to firms’ net worth, which is procyclical. While in recessions a firm’s ability to finance productive investment is constrained by its balance sheet conditions, financial frictions are mitigated in booms as higher net worth relaxes incentive constraints, thus reducing the conflict of interest with outside investors.
The dynamics of cyclical fluctuations that arise from this class of models are thus intrinsically nonlinear. The credit multiplier mechanism is more forceful the deeper the recession, but tends to disappear in a boom as improved financial conditions mitigate the agency cost of investment finance. In absence of exogenous shocks that impair balance sheets, these models are therefore unable to explain why periods of expansion may sow the seeds for future recessions.
This paper presents a model where credit market imperfections are source of endogenous business fluctuations, rather than being a mere source of propagation of exogenous shocks. The key assumption of the analysis is that the profitability of investment projects depends upon the joint effort of investors and entrepreneurs. That is, cash flows are generated under two conditions. First, entrepreneurs need to exert effort in acquiring information about project characteristics. Second, investors need to control the selection of projects, ruling out those that, for example, confer private benefit to the entrepreneur at the expense of cash flows. Underlying this assumption is the idea that bank like financial intermediaries play a dual role in lending relationships, by limiting entrepreneurs’ moral hazard through adequate control and valuations of alternative investment projects, and by assisting entrepreneurs to set up their business by means of specialized expertise.
More specifically, this paper proposes the following mechanism. An entrepreneur needs to borrow funds from a competitive investor to start one of different potential investment projects. Projects differ in terms of verifiable cash flows and non-verifiable private benefits. The entrepreneur may receive non transferable private benefits from operating or managing a project, but these private benefits are inefficient, in the sense that they reduce the project’s profitability. This generates a basic conflict of interest with the investor since the entrepreneur would like to undertake projects with some private benefits, even if this comes at the cost of lower cash flows. In contrast, the investor can only put her hands on the verifiable cash-flows and thus prefers to finance projects that maximize the size of cash flows or minimize the extent of private benefits.
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