Credit Bubbles and Misallocation

Why are bubbles harmful to the economy? According to a recent literature on rational bubbles, the problem is the burst that causes a misallocation of funds and triggers a recession. This paper proposes a theory of rational... [ view full abstract ]

Why are bubbles harmful to the economy? According to a recent literature on rational bubbles, the problem is the burst that causes a misallocation of funds and triggers a recession. This paper proposes a theory of rational bubbles where the boom, not the ensuing bust, reduces the output by promoting a misallocation of factors. As in recent literature, financial markets are imperfect and the rise of a bubble alleviates credit constraints and boosts capital accumulation. However, capital accumulation occurs in unproductive sectors and aggregate output is reduced. The result is driven by the fact that heterogeneous borrowers have an advantage with respect to issuing different types of debt contracts. In normal times, High-productive borrowers have higher collateral and thereby attract most of the funds. In bubbly times, borrowers can also issue “bubbly debt,” a debt that is repaid with future debt. The possibility to keep a pyramid scheme and raise bubbly debt depends on the probability of surviving in the market. Therefore, a bubble misallocates resources towards borrowers with low fundamental risk, even if they invest in projects with lower productivity. The theory is supported by evidence on between-industry misallocation in the years preceding the 2008 financial crisis.