Credit rationing in unsecured debt markets

We revisit the welfare properties of competitive credit markets with endogenousdebt limits that arise from limited commitment. We introduce a novel concept ofconstrained efficiency to encompass economies where market interest rates influencedefault values and participation constraints. We explore this concept through a baselineeconomy featuring heterogeneous agents with cyclical endowments. The analysis showsthat the efficiency of market equilibria and welfare outcomes are sensitive to the natureof default punishments. It suggests that laissez-faire debt limits, while supportiveof risk-sharing, might not always optimize welfare. The study illustrates how creditrationing—tightening future debt limits—can enhance current risk-sharing and overallwelfare. This occurs because such interventions influence market interest rates andthe default option’s value, thereby affecting agents’ present consumption and savingchoices, and enabling a more efficient allocation of resources.