Working Paper（25-014E）Asset Price Booms, Debt Overhang and Debt Disorganization

We propose a simplified model of financial crises that explains the empirical regularities that a credit-fueled asset-price boom tends to collapse, followed by a deep and persistent recession with productivity declines. Risk-shifting firms amplify the boom and bust of asset prices by purchasing assets with borrowed money. The resulting debt overhang reduces productivity by discouraging borrowing firms from expending additional efforts. This inefficiency leads to a demand externality that causes the production network to shrink and reduces aggregate productivity (debt disorganization). The larger asset-price boom is followed by a deeper and more persistent recession. When the debt overhang is small, the lenders forgive the debt voluntarily and achieve the social optimum, whereas they do not when the debt is large. Government subsidies to lenders for debt reduction can mitigate externality and restore productivity.

Key words: Zombie lending, bank recapitalization, time inconsistency, the debt Laffer curve.

JEL Classification: E02, G01, G33