Agency Costs, Net Worth, and Endogenous Business Fluctuations

The role of credit market imperfections as source of amplification and persistence of temporary exogenous shocks to the economy is widely accepted in the literature. Little attention has been paid to the possibility that credit frictions also generate instability. This paper proposes a theory of business fluctuations where the source of the oscillatory dynamics is an agency problem between investors and entrepreneurs. A central tenet of the theory is that investment decisions depend upon entrepreneurs' incentive to exert effort ex-ante and investors' incentive to control entrepreneurs ex-post. This double-sided incentive is used to show how recessions prevent entrepreneurs from engaging in unproductive activity and booms facilitate the adoption of unproductive arrangements, so that recessions sow the seeds for a subsequent boom while economic expansions create the conditions for their own demise.