THE JOURNAL OF FINANCE
VOL. LXXIII, NO. 1
Diagnostic Expectations and Credit Cycles
PEDRO BORDALO, NICOLA GENNAIOLI, and ANDREI SHLEIFER
We present a model of credit cycles arising from diagnostic expectations—a belief for-
mation mechanism based on Kahneman and Tversky’s representativeness heuristic.
Diagnostic expectations overweight future outcomes that become more likely in light
of incoming data. The expectations formation rule is forward looking and depends on
the underlying stochastic process, and thus is immune to the Lucas critique. Diagnos-
tic expectations reconcile extrapolation and neglect of risk in a uniﬁed framework. In
our model, credit spreads are excessively volatile, overreact to news, and are subject
to predictable reversals. These dynamics can account for several features of credit
cycles and macroeconomic volatility.
HE FINANCIAL CRISIS OF
among economists and
policy makers in the relationship between credit expansion and subsequent ﬁ-
nancial and economic busts. According to an old argument (e.g., Minsky (1977)),
investor optimism brings about the expansion of credit and investment, and
leads to a crisis when such optimism abates. Stein (2014) echoes this view by
arguing that policy makers should be mindful of credit market frothiness and
consider countering it with policy. In this paper, we develop a behavioral model
of credit cycles with microfounded expectations that is consistent both with the
Minsky narrative and with a great deal of evidence.
Recent empirical research has documented a number of credit cycle facts.
Using a sample of 14 developed countries between 1870 and 2008, Schularick
and Taylor (2012) demonstrate that rapid credit expansions forecast declines in
real activity. Jorda, Schularick, and Taylor (2013) further ﬁnd that more credit-
intensive expansions are followed by deeper recessions. Mian, Suﬁ, and Verner
(2017) show that growth in household debt predicts economic slowdowns, Baron
and Xiong (2017) show for a sample of 20 developed countries that bank credit
expansion predicts increased crash risk in both bank stocks and equity markets
Pedro Bordalo is at Sa
ıd Business School, University of Oxford. Nicola Gennaioli is at Univer-
sita Bocconi and IGIER. Andrei Shleifer is at Harvard University. Gennaioli thanks the European
Research Council and Shleifer thanks the Pershing Square Venture Fund for Research on the
Foundations of Human Behavior for ﬁnancial support of this research. The authors are also grate-
ful to Nicholas Barberis, Bruce Carlin, Lars Hansen, Sam Hanson, Arvind Krishnamurthy, Gordon
Liao, Yueran Ma, Matteo Maggiori, Sendhil Mullainathan, Andreas Schaab, Josh Schwartzstein,
Jesse Shapiro, Alp Simsek, Jeremy Stein, Amir Suﬁ, David Thesmar, Chari Varadarajan, Wei
Xiong, Luigi Zingales, and two anonymous referees for helpful comments. The authors have no
conﬂicts of interest to declare.