WP Global Economy 2016.02.09
Economic growth is known to slow down for an extended period after a financial crisis, and now there is growing concern that "secular stagnation" may follow the Great Recession of 2007-2009. In this study, we construct a model in which the one-time buildup of debt can depress the economy persistently even when there is no shock on financial technology. We consider the debt dynamics of firms under an endogenous borrowing constraint. The borrowing constraint binds tighter and production inefficiency is higher when the initial amount of debt is larger. When the initial debt reaches the maximum repayable amount, firms fall into a "debt-ridden" state in which production inefficiency stays highest permanently. In the general equilibrium with endogenous growth, the mass emergence of debt-ridden firms tightens borrowing constraints not only for themselves but also for normal firms, which may manifest as the "financial shocks" discussed in the recent macroeconomic literature. Tightening aggregate borrowing constraints lowers aggregate productivity and diminishes the labor wedge, leading to a persistent recession. This model therefore implies that debt reduction for overly indebted agents may restore economic growth in the aftermath of financial crises.