Financial Contracts with Recontracting

This paper presents a tractable model of dynamic moral hazard with purely pecuniary private benefits. To obtain a tractable but binding moral hazard problem, I introduce recontracting: the agent can offer a new continuation contract to the principal at any time which leaves him at least as well off. In addition, I use a timing convention that allows the agent to take the private action after he observes shocks, which make the optimal contract linear. The main result is that the optimal contract can be characterized as the solution to a standard portfolio problem with a linear “skin in the game” constraint, and is implementable with a sequence of short-term contracts. The setting places few restrictions on preferences and the distribution of shocks, distinguishes between observable aggregate shocks and unobservable idiosyncratic shocks, and takes general equilibrium prices as arbitrary functions of aggregate shocks. This makes results easily applicable to macro and financial settings.