Credit Markets, Financial Fragility, and the Real Economy

Abstract

The purpose of this paper is to give a review of the current issues in modern literature about the impact both of credit markets and financial fragility on macroeconomic performance. This new literature borrows heavily from the economics of information and incentives to explicitly motivate frictions in capital markets. Starting with the traditional views about the interrelationship between the financial structure of corporations and households and the business-cycle (Fisher’s debt-deflation spiral and Minsky’s financial instability-hypothesis), special attention is given to the asymmetric information-approach with regard to imperfections on credit markets. Owing to the existence of asymmetric information on these markets and the associated agency problems, the issues of adverse selection and moral hazard give rise to the phenomena of equilibrium-credit rationing and securitisation, (Greenwald-Stiglitz and Bernanke-Gertler) weakening the rate of interest as a transmission channel in monetary policy. Finally the impact of the increased financial fragility in the eighties, characterized by a deterioration of the quality of the balance sheets of the non-financial sector and depository institutions, on macroeconomic performance and stability is analyzed. Some remarks are made on the task of central banks to safeguard the stability and soundness of the whole financial system.