Enforcement, Incomplete Contracts, and Recessions

This paper studies the link between enforcement in financial contracts and output volatility. In particular we study how cycles and importantly recessions can be amplified in economies with weak contract enforcement. The idea of the paper is that firms in economies with enforcement problems will not be able to have the optimal scale of production because investors cannot enforce the collection of the large loans needed to operate at efficient levels. Moreover the value of a firm decreases over time after a sequence of bad shocks, because the firm needs to roll over an increasing larger amount of debt as output is insufficient to cover the uncontingent debt payments in low shocks. Thus as low aggregate shocks hit the economy an increasing fraction of firms experience a reduction in their value exacerbating enforcement frictions and the inefficiency in scale which further amplifies the recession. * [email protected] Υ [email protected] ** [email protected]