Long-Term Debt, Default, and Firm-Targeted Stimulus during Severe Recessions (job market paper, draft available here)
A growing empirical literature finds that long-term debt and its maturity reduce firm-level investment, particularly during recessions. I introduce long-term debt maturity, alongside short-term financial savings, into an otherwise standard general equilibrium model in which heterogeneous firms borrow subject to default risk. A stochastic process governs whether all or none of a firm’s debt matures in a period. This allows the model to capture the persistent negative effect of maturing debt on investment found in the data.
I apply the model to the 2020 recession to assess how firm investment responds to a severe recession and to evaluate the effects of firm-targeted stimulus at the firm- and aggregate level. Absent stimulus, the model generates a large, brief, contraction, during which maturing debt lowers investment more than in ordinary times. Cash grants boost firm investment, accelerating the recovery. However, this acceleration increases the long-term risk-free interest rate that anchors firm loan rate schedules, making borrowing more expensive. The higher borrowing costs outweigh the benefits of cash grants for the most indebted firms, increasing defaults over the recession’s first year. An alternative policy that lowers long-term interest rates is more effective at reducing rollover risk and preventing defaults. However, it has little effect on larger firms’ investment demand and therefore has small aggregate effects. When combined, cash grants and rate reductions strengthen the economic recovery and lower the default rate.
We study the propagation of recessions in overlapping generations economies wherein households, with uncertain lifetimes and uninsurable earnings risk, face cyclical employment risk. Business cycles are driven by persistent shocks to TFP growth and household-level employment. Increases in employment risk cause fluctuations in both the unemployment rate and in labor force participation. In this setting, we introduce elements commonly used to deliver a strong and countercyclical precautionary savings motive. Specifically, households have non-separable utility characterized by high levels of risk aversion, and a diminishing marginal productivity of investment leads to a time-varying price of capital.
We find that changes in precautionary savings, following aggregate shocks, have important implications for aggregate consumption. Persistent negative shocks to TFP growth, associated with increases in risk to employment, drive large declines in consumption. This helps explain the large fall in consumption observed over the Great Recession. An empirically consistent, moderate shock to TFP growth rates implies a large and persistent fall, against trend, in aggregate consumption. Moreover, an estimated rise in households’ risk of long-term non-employment reduces labor force participation and reconciles the swift recovery in TFP growth rates with a protracted decline in consumption and output.
Works in Progress
Earnings Risk, Portfolio Heterogeneity, and the Racial Wealth Gap in the US
The Propagation Effects of Long-Term Debt Maturity on Business Cycles
Unconventional Monetary Policy over the Business Cycle