Breaking the Spell with Credit-Easing: Self-Confirming Credit Crises in Competitive Search Economies

We analyze an economy where banks are uncertain about firms' investment opportunities and, as a result, credit tightness can result in excessive risk-taking. In the competitive credit market, banks announce credit contracts and firms apply to them, as in a directed search model. We show that high-risk Self-Confirming Equilibria, with misperceptions, coexist with a low-risk Rational Expectations Equilibrium, in this competitive search economy. Lowering the Central Bank policy rate may not be effective, while a credit-easing policy can be an effective experiment, breaking the high-risk (low-credit) Self-Confirming Equilibrium. We emphasize the differences with a model of Self-Fulfilling credit freezes and the social value of experimentation.