Firm Dynamics and Growth with Soft Budget Constraints

We develop a model of endogenous growth and firm dynamics with soft budget con-straints, where firms differ in their innovation speed and slower firms need additional fin-ancing in order to eventually innovate. As creditors cannot anticipate refinancing needs inadvance nor credibly commit to withholding future refinancing, aSoft Budget ConstraintSyndromeemerges, causing excessive entry by slow firms and crowding out potentiallymore efficient innovators. The resulting trade-off between the positive effects of budgetconstraint softening on innovation by incumbents and slow-type entrants and its negat-ive effects on entry by fast innovators, generates a hump-shaped relationship betweenrefinancing costs and aggregate growth. Calibrating the model to French firm-level data,we show that the budget constraint softening associated with the decline in interest ratesin the aftermath of the Global Financial Crisis accounts for 54% of the observed drop inthe aggregate growth rates post-crisis. Although the softening in budget constraints hashad a positive effect on incumbent innovation, this was more than offset by the resultingdecrease in the entry rates of good firms (by 61% relative to the pre-crisis steady state)