Reflexivity in Credit Markets

Robin  Greenwood; Samuel G. Hanson; Lawrence J. Jin

Working Paper | 2019

Reflexivity in Credit Markets

by Robin Greenwood, Samuel G. Hanson and Lawrence J. Jin

Abstract

Reflexivity is the idea that investors' biased beliefs affect market outcomes, and that market outcomes in turn affect investors' beliefs. We develop a behavioral model of the credit cycle featuring such a two-way feedback loop. In our model, investors form beliefs about firms' creditworthiness, in part by extrapolating past default rates. Investor beliefs influence firms' actual creditworthiness because firms that can refinance maturing debt on favorable terms are less likely to default in the short run—even if fundamentals do not justify investors' generosity. Our model is able to match many features of credit booms and busts, including the imperfect synchronization of credit cycles with the real economy, the negative relationship between past credit growth and the future return on risky bonds, and "calm before the storm" periods in which firm fundamentals have deteriorated but the credit market has not yet turned.

Keywords: reflexivity; Attitudes; Financial Markets; Forecasting and Prediction; Investment; Credit;

Language: English

Format: Print

45 pages

Read Now

Citation:

Greenwood, Robin, Samuel G. Hanson, and Lawrence J. Jin. "Reflexivity in Credit Markets." NBER Working Paper Series, No. 25747, April 2019.

We develop a model of government portfolio choice in which a benevolent government chooses the scale of risky projects in the presence of market failures and tax distortions. These two frictions generate motives to manage social risk and fiscal risk. Social risk management makes attractive programs that ameliorate market failures in bad economic times. Fiscal risk management makes unattractive programs that entail large government outlays at times when other programs in the government's portfolio also require large outlays. We characterize the determinants of social and fiscal risk and argue that these two risk management motives often conflict. Using the model, we explore how the attractiveness of different financial stability programs varies with the government's fiscal burden and with characteristics of the economy.

Faculty & Research

Reflexivity in Credit Markets

Abstract

Citation:

About the Authors

More from these Authors