Firm Quality Dynamics and the Slippery Slope of Credit Intervention
Charles A. Dice Working Paper No. 2020-28
82 Pages Posted: 1 Dec 2020 Last revised: 19 Oct 2021
Date Written: October 4, 2021
Crises have cleansing effects: Low-quality firms face greater financial shortfalls and invest less than high-quality firms. Public liquidity support preserves the overall production capacity. However, by dampening the cleansing effects, it distorts the quality distribution and reduces the total productivity. The trade-off between quantity and quality determines the optimal size of intervention. The distortionary effects on quality are self-perpetuating: A downward bias in quality necessitates interventions of greater scales in future crises, implying further distortions. The distortions are also amplified by the expectations of liquidity support that motivate low-quality firms to overinvest pre-crisis. Finally, the size of optimal intervention is larger and the distortionary effects stronger in a low interest rate environment where the low yield on savings discourage firms from self-insurance against crises through internal liquidity accumulation.
Keywords: heterogeneous firms, firm distribution, credit intervention, liquidity facility, unconventional monetary policy, collateral, limited commitment, corporate liquidity management, disaster, financial crises, Covid-19 pandemic
JEL Classification: E0, G0
Suggested Citation: Suggested Citation