Agency problems and endogenous economic fluctuations

This paper proposes a theory of investment fluctuations where the source of the oscillating dynamics is an agency problem between financiers and entrepreneurs. A central tenet of the theory is that investment decisions depend upon entrepreneurs’ initiative to select investment projects ex-ante, and financiers’ incentive to control entrepreneurs ex-post. Too much control discourages entrepreneurial incentive to initiate new investment, while too little control jeopardizes its productivity. This initiative-control trade-off generates investment dynamics that mimic those of a standard credit frictions model, in which more entrepreneurial net worth leads to higher investment. The same trade-off is capable of generating endogenous reversal of investment booms, induced by an ongoing deterioration of project profitability. Investment fluctuations may take place even though no external shocks hit the economy, and even though agents are perfectly rational.