WP Global Economy 2023.01.19
This is a working paper.
Persistent stagnation often follows a financial crisis. We construct a model in which a debt buildup in the corporate sector can persistently depress the economy, even when there are no structural changes. We consider endogenous borrowing constraints on short-term and long-term debt. A firm is referred to as debt-ridden when its long-term debt is so large that it can never decrease even though the firm pays all income in each period to the lender. A debt-ridden firm continues inefficient production permanently, and the emergence of a substantial number of debt-ridden firms causes a persistent recession. Further, if the initial debt exceeds a certain threshold, the firm intentionally chooses to increase borrowing and, thus, becomes debt-ridden. We numerically show successive productivity shocks or a large wealth shock can generate debt-ridden firms. The relief of debt-ridden borrowers from excessive debt may be effective for economic recovery.