Self-Fulfilling Credit Market Freezes

Abstract:     
This paper develops a model of a self-fulfilling credit market freeze and uses it to study alternative governmental responses to such a crisis. We study an economy in which operating (nonfinancial) firms are interdependent, with their success depending on the ability of other operating firms to obtain financing. In such an economy, we show, inefficient credit market freeze may arise in which banks abstain from lending to operating firms with good projects because (and only because) of their (self-fulfilling) expectations that other banks will not be lending. We show how inefficient credit freeze equilibria may result from the arrival of information about fundamentals or a negative shock to the banking system's capitalization. While such equilibria result from the arrival of information about fundamentals, they do represent a "coordination failure:" banks' separate and fully rational decisions produce an outcome that would have been avoided had they been able to choose a coordinated action.

Our model enables us to study the effectiveness of alternative measures for getting an economy out of an inefficient credit market freeze. In particular, we study the effectiveness of (1) interest rate cuts, (2) infusion of capital into financial firms, (3) infusion of capital under terms that commit financial firms receiving it to use it to extend loans, (4) direct lending to operating firms by the government, and (5) lending to operating firms by funds owned by the government and managed by private agents compensated with a share of the profits generated by the fund. Throughout, we discuss the implications of our analysis for understanding and responding to the credit crisis of 2008.

A detailed discussion of the implementation and institutional design of alternative forms of government intervention to produce a credit thaw is provided in Bebchuk, "Unfreezing Credit Markets," available at: http://papers.ssrn.com/abstract=1315436

Keywords: Credit freeze, credit crunch, credit thaw, self-fulfilling crisis, run on the economy, global game, coordination failure, bank capital, lending, strategic complementarities

JEL Classifications: D21, E44, E50, E58, E62, G18, G21, G28, H50, P11

Working Paper Series