Large Recessions, Debt and Heterogeneity
Paper Session
Saturday, Jan. 7, 2023 8:00 AM - 10:00 AM (CST)
- Chair: Aubhik Khan, Ohio State University
Firm Heterogeneity, Leverage and the Aftermath of the Pandemic
Abstract
The severe economic downturn brought on by Covid-19 saw large declines in production and employment across the distribution of firms. We argue that the high levels of indebtedness seen at the onset of the recession could have had persistent real effects on the recovery following the aftermath of the global pandemic. In a model of entrepreneurship with entry, exit and a time-varying distribution of production, we examine the effects of differences in initial leverage on the severity and duration of recessions. Entrepreneurs finance their businesses using loans subject to default risk. They hold liquid assets that serve as collateral; their debt is illiquid. Productive entrepreneurs without collateral cannot undertake high levels of investment given the effect of rising leverage on default risk and loan rates. This results in a misallocation of capital and labor. Misallocation rises after a severe downturn that worsens balance sheets in the absence of large-scale government intervention. Relative to a model with risk-neutral firms, the recession is worsened as entrepreneurs reduce investment to dampen the fall in their consumption. Balance sheets are further worsened, and an economic recovery is a gradual process as many borrowers struggle to fund capital spending. We find that the distribution of leverage has substantial implications for the speed of the recovery. When aggregate leverage is a third higher than its long run mean, a large negative TFP shock drives a sharp rise in default. This causes a pronounced and persistent reduction in the number of businesses which, in turn, reduces the endogenous component of aggregate total factor productivity. The subsequent economic recovery is slower; the half life of output rises from 7.5 years to 15 years. We have one of the first quantitative business cycle models with production heterogeneity where financial factors amplify large nonfinancial recessions.Public Debt and Welfare in a Quantitative Schumpeterian Growth Model with Incomplete Markets
Abstract
This paper quantifies the welfare effects of counterfactual public debt policies using an endogenous growth model with incomplete markets. The economy features public debt, Schumpeterian growth, infinitely-lived agents, uninsurable income risk, and discount factor heterogeneity. Two versions of the model are specified, one with households holding equity in the group of innovating firms. The model is calibrated to the U.S. economy to match the degree of wealth inequality, the share of R&D expenditure in GDP, the firms' exit rate, the average growth rate, and other standard long-run targets. When comparing balanced growth paths, I find large long-run welfare gains in equilibria characterized by governments accumulating public wealth. In some parameterizations, the equilibrium response of the growth rate is modest. However, welfare effects decompositions show that the growth component is still an important determinant of the welfare gains in the equilibria characterized by public wealth. The version of the model without equity is computationally easier to solve, allowing to consider transitional dynamics. Taking into account the dynamic adjustment to the new long-run equilibrium shows that the transitional welfare costs are not large enough to change the sign of the welfare effects stemming from a change in public debt. I find that eliminating public debt would lead to a 1.7% increase in welfare, while moving to a debt/GDP ratio of 100% would entail a welfare loss of 0.8%.The Persistence of Recessions with Incomplete Markets and Time-Varying Income Risk
Abstract
TBDJEL Classifications
- D25 - Intertemporal Firm Choice: Investment, Capacity, and Financing
- E62 - Fiscal Policy