Financial Distress, Bankruptcy Law and the Business Cycle

(Formerly: “A Stylized Model of Financially-Driven Business Cycles”)

Oren Sussman, Saïd Business School, University of Oxford
Javier Suarez, CEMFI and CEPR
June 2, 2005

Abstract
This paper explores the business cycle implications of financial distress and bankruptcy law. We find that due to the presence of financial imperfections the effect of liquidations on the price of capital goods can generate endogenous fluctuations. We show that a law reform that ‘softens’ bankruptcy law may increase the amplitude of the cycle in the long run. In contrast, a policy of bailing out businesses during the bust, or actively managing the interest rate across the cycle, could stabilize the economy in the long run. A comprehensive welfare analysis of the policy is provided as well.