Long-term debt and the efficiency of crisis-contingent policies: Taming overborrowing externalities

Credit market interventions that stabilize economies ex post are typically blamed for the moral hazard arising from firms’ anticipation of government relief. This view, based on short-term debt models, overlooks the important role of long-term debt in corporate finance. We develop a dynamic general equilibrium model to study the design of credit market interventions in the context of long-term debt and financial frictions. In the model, firms overborrow due to pecuniary externalities, where collective investments inflate factor prices, resulting in excessive debt and amplified financial fragility. With interest rate subsidies in sight, firms anticipate cheaper future borrowing and, constrained by collateral limits, reduce current long-term debt to preserve future capacity, curbing overborrowing. Optimal Pigovian taxes that take into account this incentive effect of long-term debt lead to a welfare gain of 1.02% ∼ 1.23%, and we find empirical support for this mechanism using US manufacturing data.