The preceding chapters have shown that debt accumulation when combined with price dynamics may give rise to instability. A stylised fact of periods of financial fragility is that over-indebtedness leads to the insolvency of borrowers. Firms go bankrupt and default on loans. The impact of the failure of firms and non-performing loans plays a central role in the theories of financial fragility developed by Minsky and Fisher. Nonperforming loans may have a boomerang effect on the financial sector, by undermining the profitability of commercial banks. In this chapter, the preceding models are extended to take into account three aspects of debt over-indebtedness over the business cycle:

1. Bankruptcy of firms

2. Debt default

3. Non-performing loans and banking crises.

Bankruptcies may have ambiguous effects on the business cycle. On the one hand, the market sanctions bad performance by bankruptcy. It eliminates the weakest and most fragile firms and establishes favourable conditions for economic recovery. Similarly, in a Schumpeterian approach, the creative destruction argument points in the same direction. Recessions are productive as they are periods during which new technologies and new organisations are implemented. Likewise, bankruptcy also improves the average output to capital ratio, which paves the way for economic recovery. This is in fact a key element of the so-called reproductive cycle (see Gordon et al. (1983)). On the other hand, using a Keynesian line of argument bankruptcies may have a destabilising effect on consumption through unemployment and nominal wages.