Essays on credit booms and rational bubbles

Why are credit booms and bubbles harmful to the economy? A dominant view points to the risk of bust. Traditional theories of bank runs and recent theories of rational bubbles describe the costs of jumping to a bad equilibrium when the economy accumulates too much debt. In this work, I propose a theory of rational bubbles where the boom, not the ensuing bust, reduces the output by promoting a misallocation of factors. In the model presented in Chapter 2, 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. In Chapter 3, I propose an augmented version of the model with nominal rigidities. The goal is to explain the timing of expansions and recessions during “bubbly episodes.” In this version of the model, the initial boom in output is caused by a positive demand effect; the long run reduction in TFP is driven by a misallocation process. In this chapter, I also analyze the optimal policy prescriptions. In particular, I stress the importance of the central bank monopoly on the issuing of bubble-like instruments. Finally, Chapter 4 presents an investigation of American banks’ balance sheets motivated by the theory of the previous chapters. I test models of credit bubbles versus models of liquidity transformation. I provide evidence that the recent expansion in liquid debt instruments can be interpreted by the emergence of a bubble on bank’s liabilities.Arts, Faculty ofVancouver School of EconomicsGraduat