Inequality, Financial Frictions, and Leveraged Bubbles

Abstract

We analyze collateralizable rational asset bubbles in an overlapping generations model with credit frictions. We show that an increase in the pledgeability of assets (or “easy credit”) relaxes the conditions for the existence of endogenously leveraged bubbles. With low pledgeability, bubble investment is unleveraged, as the bubbly asset simply serves as an investment vehicle for savers. However, with high pledgeability, bubble investment becomes leveraged, as credit-constrained borrowers find it optimal to buy the bubbly asset using collateralized loans. Furthermore, the collapse of leveraged bubbles leads to equilibrium default. The model predicts a relationship between boom-busts in asset prices and collateralized credit that is broadly consistent with documented characteristics of the recent financial crisis. Finally, we provide an open economy application, which illustrates the relevance of our theory for understanding how the global savings glut might have facilitated the leveraged housing bubble episode in the U.S.