WP Global Economy 2014.05.21
Many authors argue that financial constraints have been tightened in several countries since the Great Recession in 2007-2009. To explain this, we construct a model in which borrowing constraints for firms are tightened as a result of mass default due to a bubble collapse. In Jermann and Quadrini's (2012) model, a defaulting firm either goes back to being a normal firm by (partially) repaying its debt or is liquidated. We assume that there is an intermediate status: a "debt-ridden" firm, defined as a firm whose lender retains the right to liquidate it. The lender allows the debt-ridden firm to continue if it pays continuation fee. In our model, debt forgiveness is infeasible: once a firm defaults on the debt, it is either liquidated or kept as a debt-ridden firm. The defaulter cannot go back to being a normal firm, unless it repays all its debt. Prohibition of debt forgiveness can be justified as a collective choice of the society, in order to expand the borrowing limit for normal firms.
It is shown that borrowing constraints are tighter for debt-ridden than for normal firms. This implies that the emergence of a large mass of debt-ridden borrowers may be a cause of the "financial shocks" discussed in recent macroeconomic literature. Tightened borrowing constraints due to the emergence of debt-ridden firms lower the aggregate productivity. This negative effect on productivity can be permanent. In a version of the model with endogenous growth, the growth rate of aggregate productivity becomes zero if the number of debt-ridden firms exceeds a certain threshold.