Why are credit-driven crises deep and long-lasting?

Abstract

There is evidence that transitory credit market shocks produce permanent effects on GDP trend. The most notable example of this phenomenon is the break in trend GDP in the US following the Great Recession of 2008. While many papers deal with the consequences of credit disruptions at the firm level, to the best of our knowledge, ours is the first to propose a theory linking shocks to household borrowing capacity to trend GDP. We build a general equilibrium, endogenous growth model with credit in the household sector. Consumers face idiosyncratic liquidity shocks, and use credit to smooth consumption while financing capital investments that are illiquid. A credit crunch –even though totally transitory– produces a recession and a permanent downward effect on the level of GDP trend, of the type believed to have occurred in the Great Recession of 2008. The key driver responsible for this result is the interaction between the liquidity risks that households face and the illiquid nature of capital investments.