Soft credit lowers volatility but slows growth

A new Federal Reserve working paper finds that policies saving distressed firms reduce economic volatility but also slow long-term growth. Researchers developed a dynamic general equilibrium model to assess this fundamental trade-off.

The dual impact of soft credit

A new dynamic general equilibrium model with business cycles, endogenous growth, and innovation externalities assesses the fundamental stabilization-vs.-growth trade-off.

The model, disciplined by microeconomic data, examines interventions like credit guarantees, debt restructuring, and loan evergreening.

These 'soft credit' regimes consistently reduce the share of firms exiting, thereby lowering output and employment volatility.

However, by keeping less productive firms alive, the average productivity of incumbent firms falls.

This, in turn, increases R&D costs for other firms due to calibrated innovation externalities, leading to reduced R&D investment and slower economic growth.

The study finds that a 'hard credit' economy, without such interventions, features 0.33-0.39 percent higher GDP growth per year compared to soft credit economies.

Welfare favors hard credit

The model is tightly calibrated to U.S. empirical moments, including lending spreads, default rates, and loan recovery rates.

Comparing the 'hard credit' benchmark (no ex-post interventions) with soft credit counterfactuals, the research computes aggregate welfare.

Welfare is found to be largest in the hard credit economy due to its stronger economic growth.

Restructuring and guarantee economies deliver around 2.3 percent lower welfare, while the evergreening economy shows 3 percent lower welfare.

This poorer performance is attributed to distortions in firm labor choices, leading to higher labor demand, increased wages, lower firm profits, and reduced R&D investment.

Short-term gains, long-term pain

A benevolent government with commitment would optimally choose a hard credit regime, avoiding ex-post interventions.

However, policymakers acting under discretion prioritize short-term stabilization by saving distressed firms, leading to larger welfare losses.

This explains the prevalence of soft credit, as short-term political incentives often outweigh long-term economic efficiency despite the costs.