Cheap Credit Means Crummy Companies - Fed Researcher

This makes too much sense to me so it is almost certainly not as neat as it seems, but it’s still a fascinating conclusion. As a NY Fed researcher shows, cheap credit makes for crummy and over-fragile companies. At the same time, however, companies founded in periods of tight credit have trouble adapting when money becomes free and easy.

Empirical studies show that competition in the credit markets has important effects on the entry and growth of firms in nonfinancial industries. This paper explores the hypothesis that the availability of credit at the time of a firm’s founding has a profound effect on that firm’s nature. I conjecture that in times when financial capital is difficult to obtain, firms will need to be built as relatively solid organizations. However, in an environment of easily available financial capital, firms can be constituted with an intrinsically weaker structure. To test this conjecture, I use confidential data from the U.S. Census Bureau on the entire universe of business establishments in existence over a thirty-year period; I follow the life cycles of those same establishments through a period of regulatory reform during which U.S. states were allowed to remove barriers to entry in the banking industry, a development that resulted in significantly improved credit competition. The evidence confirms my conjecture. Firms constituted in post-reform years are intrinsically frailer than those founded in a more financially constrained environment, while firms of pre-reform vintage do not seem to adapt their nature to an easier credit environment. Credit market competition does lead to more entry and growth of firms, but also to complex dynamics experienced by the population of business organizations.

Source:

Credit Market Competition and the Nature of Firms
Nicola Cetorelli
Federal Reserve Bank of New York Staff Reports, no. 366
March 2009
JEL classification: L20, G20

Comments

[PainfullyAware:]

Money Gained Without Effort Is Usually Spent Foolishly.

Apr 14 09:26 PM

[Jasper M:]

EXcellent work. Thank you.

Apr 14 09:45 PM

[Roowns:]

The reason is the market is very weak, competitions is at all high time so new firms have trouble to enter market even the credit is cheap.
If it was so easy, the existing firms would put the cheap credit to work in no time.
What to do with cheap money when then nobody wants to buy products ? Spend it with marketing ? No way.

Apr 15 06:50 AM

[Scott Sambucci:]

Hi Paul - Thanks for posting. There's an economic concept known as "the Tragedy of the Commons" that can be related to the current credit market and government "stimulus" programs in place. This definitely qualifies.... I did some research on this after reading about how California, Ohio, and Illinois were going after infrastructure funding:

freemarketvoice.org/20.../

Apr 15 09:13 AM

[Allan Frain:]

This phenomenon is referred to as Capital Destruction:

www.marketoracle.co.uk...

Apr 15 09:48 PM