Ebook Productivity Losses from Financial Frictions: Can Self-Financing Undo Capital Misallocation?
Underdeveloped countries often have underdeveloped financial markets. This can lead to an inefficient allocation of capital, in turn translating into low productivity and per-capita income. But available theories of this mechanism often ignore the effects of financial frictions on the accumulation of capital and wealth. Even if an entrepreneur is not able to acquire capital in the market, he might just accumulate it out of his own savings.
The implications of such effects are not well understood. To explore them, this paper proposes a tractable dynamic theory featuring heterogeneous entrepreneurs who are subject to borrowing constraints. It then applies the theory to quantify productivity losses from financial frictions, using plant-level panel data from two emerging market economies.
Consider an entrepreneur who begins with a business idea. In order to develop his idea, he requires some capital and labor. The quality of his idea translates into his productivity in using these resources. He hires workers in a competitive labor market. Access to capital is more difficult, due to borrowing constraints: the entrepreneur is relatively poor and hence lacks the collateral required for taking out a loan. Now consider a country with many such entrepreneurs: some poor, some rich; some with great business ideas, others with ideas not worth implementing. In a country with well-functioning credit markets, only the most productive entrepreneurs would run businesses, while unproductive entrepreneurs would lend their money to the more productive ones.
In practice credit markets are imperfect so the equilibrium allocation instead has the features that the marginal product of capital in a good entrepreneur’s operation exceeds the marginal product elsewhere. Reallocating capital to him from another entrepreneur with a low marginal product would increase the country’s GDP. Failure to reallocate is therefore referred to as a “misallocation” of capital. Such a misallocation of capital shows up in aggregate data as low total factor productivity (TFP). Financial frictions thus have the potential to help explain differences in per-capita income. Of course, resources other than capital can also be misallocated. I focus on the misallocation of capital because there is empirical evidence that this is a particularly acute problem in developing countries.
The argument just laid out has ignored the fact that capital and other assets can be accumulated over time. Importantly, it has therefore also ignored the possibility of self-financing: an entrepreneur without access to external funds can still accumulate internal funds over time to substitute for the lack of external funds. Moving to a dynamic setting therefore uncovers a counteracting force to the misallocation described in the static setting in the paragraph above. Self-financing has the potential to undo capital misallocation. As I will argue below, the outcome of the tug-of-war between self-financing and capital misallocation depends crucially on the evolution of individual productivities over time, leading me to consider a setting with idiosyncratic productivity shocks.
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