Productivity Losses from Financial Frictions: Self-Financing, Growth and Endogenous Productivity
The objective of this paper is two-fold. Firstly I develop a tractable general equilibrium model featuring heterogeneous agents facing financial constraints and endogenous evolution of entrepreneurial productivity. The key mechanism I explore is the interaction between growth, self-financing and misallocation. Consider an economy with underdeveloped financial system with the presence of severe financial frictions which distorts the allocation of capital across agents. This static misallocation acts as a tax on growth, because there are two competing forces that individuals are facing. Firstly, agents who are financially constraint want to save to undo these constraints, but on the other hand their optimal scale is increasing due to growth and hence they have incentives to allocate resources to grow. Therefore, I ask the question, does this mechanism alleviate the effects from the self-financing channel, thus amplifying the effects on productivity losses.
In this paper, I propose a tractable general equilibrium model of heterogeneous entrepreneurs, financial frictions and endogenous productivity. I show that financial frictions can potentially have larger impacts on productivity losses through the lens that capital misallocation will act as a tax on growth. In the presence of collateral constraints, entrepreneurs are not able to operate at their optimal scale generating a dispersion in the marginal products of capital across entrepreneurs, which we can think of as misallocation. However, if productivity remains persistent entrepreneurs have incentives to save, accumulate wealth and self finance away from financial constraints. However, with growth in the economy, entrepreneurs optimal scale is increasing, hence they face a tradeoff between saving to undo the financial constraints or to put resources to grow. Therefore, the misallocation of capital through financial frictions imposes a tax on growth and can amplify productivity losses.
It is important to highlight that much of the tractability of the model relies heavily on the CRTS assumption of individual production function. However, this implies that in the first-best or benchmark economy only the most productive entrepreneur will be active which is a counterfactual. The existing quantitative literature does not face such an issue as the individual production functions exhibit decreasing returns to scale. Thereby, resulting in a first-best or benchmark economy which will ensure that all entrepreneurs are active but more resources are allocated to more productive entrepreneurs. Furthermore, to assess the true quantitative importance of financial frictions on aggregate productivity in an economy with growth, it is instructive to generalize the model to have DRS at the individual production unit and occupational choice. Therefore, in a state where I loose tractability through endogenizing the entrepreneurial productivity process, I will follow the quantitative literature and conduct numerical exercises. In addition, I will abstract from tractability assumptions and generalize the model to allow for occupational choice and decreasing returns to scale at the individual production function.
