Lemon Cycles

Abstract

We build a model of endogenous credit cycles arising from the dynamics of adverse selection. Heterogeneous entrepreneurs trade productive assets in an anonymous market subject to financial frictions. Cream-skimming rent-seekers create lemon assets that can be traded. Lemon assets are indistinguishable ex-ante from the productive assets but have no productive value ex-post. The average quality of assets is the key state variable of the economy. High asset prices today attract the creation of more lemons, thereby exacerbating adverse selection and depressing the future reallocation of productive assets and asset prices. Productive and lemon assets therefore exhibit predator-prey dynamics, and the quality of assets evolves endogenously over time. The equilibrium may feature endogenous cycles and chaos, with the credit market freezing and thawing recurrently and with deterministic ups and downs in asset prices and the volume of trades. We show that a social planner has incentives to tax credit market activities in order to reduce lemon assets and to eliminate endogenous cycles.

Keywords: dynamic adverse selection, endogenous cycles, credit expansion, systemic risk, predator-prey dynamics.

JEL Classification: D82, E32, E44, G01