Working Paper（26-015E）Financial Crisis Cycles

This paper develops a theoretical model of financial crisis cycles where credit-driven asset price booms are followed by busts and protracted recessions. The accumulation of private debt during booms generates a debt overhang that discourages borrowers from enhancing productivity in the post-crash period. When this debt burden is substantial, coordination failures among creditors delay necessary debt restructuring, leading to a persistent decline in aggregate productivity. We show that bank recapitalization or subsidies, conditional on debt restructuring, are more efficient than unconditional subsidies to borrowing firms, achieving economic recovery at a lower fiscal cost. Furthermore, we demonstrate that borrower subsidies, or expansionary fiscal policy more broadly, can inadvertently prolong stagnation by discouraging banks from restructuring debt.