Slow Debt, Deep Recessions
57 Pages Posted: 2 Dec 2020
Date Written: March 1, 2020
Business credit lags GDP growth by about one year. This contributes to high leverage during recessions and slow deleveraging. We show that a model in which firms use risky long-term debt replicates this slow adjustment of firm debt. In the model, slow-moving debt has important effects for real activity. High levels of firm debt issued during expansions are only gradually reduced during recessions. This generates an adverse feedback loop between high default rates and low investment and thereby amplifies the downturn. Sluggish deleveraging slows down the recovery. The equilibrium is constrained inefficient because firms exert an externality on the holders of previously issued debt. The constrained efficient allocation substantially reduces macroeconomic volatility.
Keywords: business cycles, firm financing, long-term debt
JEL Classification: E32, E44, G32
Suggested Citation: Suggested Citation