WP Global Economy 2020.03.30
This is working paper.
Firms and households occasionally accumulate debt beyond the level they can repay, particularly at times of financial distress. However, debt restructuring can take a considerable amount of time.
In this paper, we propose a model of a long-term debt contract with a time-consuming debt restructuring process, and demonstrate that large debt can cause persistent inefficiency. The key is that if the debt is accumulated beyond a threshold level, the lender can no longer commit to any future repayment plans. The loss of lender's credibility then discourages the borrower's demand for new loans and leads to an inefficient outcome. This contrasts with the existing theory based on credit crunch or debt overhang, where it is the supply of new loans that is dampened. Our model generates a debt Laffer curve, i.e., the lender's payoff may decrease with the contractual amount of debt.
Key words: Optimal contract, backloading, two-sided lack of commitment, secular stagnation.