Default Cycles

With Leo Kaas. Journal of Monetary Economics, 2021.

This paper develops a macroeconomic theory in which corporate default and credit conditions are jointly shaped by self-fulfilling beliefs. Default damages firms’ future access to credit, so current default incentives depend on how valuable firms expect future credit-market participation to be. Optimistic beliefs support low default and low spreads, while pessimistic beliefs can generate high default, tighter credit, and persistent recessions.

1. Corporate default can be driven by self-fulfilling credit-market beliefs

A well-functioning credit market makes continued access to borrowing valuable, discouraging firms from defaulting. Pessimistic expectations reduce that value, increase default incentives, and validate the initially weak credit conditions.

2. Belief shocks jointly explain default, spreads, and persistent credit contractions

Unlike conventional recovery-rate or intermediation shocks, adverse belief shocks generate a persistent rise in both corporate default and credit spreads, together with declining leverage, credit, productivity, and output growth.

3. Belief-driven default cycles are quantitatively important

In the estimated model, belief shocks explain about 56% of corporate-default volatility, 31% of credit-spread volatility, and nearly 40% of output-growth volatility. Endogenous default also worsens capital allocation because fewer productive firms retain access to credit.