Essays on financial frictions and productivity

Abstract

Productivity - the efficiency with which firms transform inputs into outputs - is the root of economic growth and the improvement of living standards. This thesis explores different financial frictions that affect productivity at the corporate level and their aggregate consequences. The first chapter, “Credit Market Frictions and the Productivity Slowdown”, is joint work with John Van Reenen and Timothy Besley. UK labour productivity growth has been particularly weak since the financial crisis. We develop a theoretical framework to quantitatively assess the magnitude of financial frictions and their impact on aggregate productivity. We apply this framework to administrative panel data on UK firms. The approach highlights a firm’s default probability as a sufficient statistic for credit frictions. We use Standard and Poor’s "PD Model" algorithm to measure market participants’ perceptions of firm-specific default risk. The theoretical framework suggests an aggregate measure of credit market inefficiency which we show can be applied to UK administrative panel data to explain how far the dramatic productivity slowdown in the wake of the crisis is due to credit market frictions. We find that credit frictions cause a loss of 7% to 9% of GDP on average per year in 2004-12. These frictions increased during the crisis and lingered thereafter accounting for between one-quarter and one-third of the productivity fall in 2008-2009 and of the gap between actual and trend productivity by the end of 2012. The second chapter, “Management practices, precautionary savings, and company investment dynamics”, investigates a potential channel behind the well-documented positive correlation between the quality of management practices and firm performance. The main hypothesis of the paper is that financially constrained firms accumulate larger cash reserves when they are better managed. This allows them to avoid the costs of underinvestment when future profitable investment opportunities arise. The theoretical analysis predicts that well managed firms which face financial constraints save relatively more out of their cash flows and accumulate more cash when their cash flows are more volatile. This enhanced precautionary behaviour arises because management quality alleviates agency problems between equity holders and managers. The empirical analysis provides evidence to support these predictions using data from the World Management Survey and administrative and accounting data on UK firms. A direct consequence of this enhanced precautionary behaviour is that well managed firms invest more efficiently. Specifically, they adjust more quickly towards their long-run equilibrium capital stock when their current capital stock falls short of the latter. The paper provides evidence of this using a dynamic model of investment. The third chapter, “When Does Leverage Hurt Productivity Growth? A Firm-Level Analysis”, is joint work with Fabrizio Coricelli, Nigel Driffield, and Sarmistha Pal. Following the global financial crisis, several macroeconomic contributions have highlighted the risks of excessive credit expansion. In particular, too much finance can have a negative impact on growth. We examine the microeconomic foundations of this argument, positing a non-monotonic relationship between leverage and firm-level total factor productivity (TFP) growth. A threshold regression model estimated on a sample of Central and Eastern European countries confirms that TFP growth increases with leverage until the latter reaches a critical threshold beyond which leverage lowers TFP growth. We find similar non-monotonic relationships between leverage and proxies for firm value. The fourth chapter, “The sullying effect of credit sclerosis on productivity”, explores the impact of depressed credit flows on productivity in a partial equilibrium search and matching model of the banking market. Reputational costs associated with the termination of lending relationships drive a wedge between rates on new and existing loans. This induces misallocation of capital across borrowers. The phenomenon is one of "credit sclerosis": Low-productivity firms are kept alive through subsidised loan rates, while high-productivity entrants face an inefficiently high cost of borrowing and limited supply of new loan facilities. As a consequence, too much credit is allocated to old firms. Aggregate labour productivity and TFP are reduced. The model also sheds some light on why a policy tool like the UK’s Funding for Lending Scheme might fail to revive productivity in the presence of costly loan termination