Schumpeter meets goldilocks: the scarring effects of firm destruction

The COVID-19 shock impacted firms severely all over the world. Governments were swift to implement policy measures to aid these firms, but these are coming to an end in the midst of a highly uncertain macroeconomic environment as a result of the war in Ukraine and the surge in energy prices. In this context, policymakers are worried about the potential increase in firm destruction after support policies are lifted, and what its macroeconomic consequences could be. Using data for Spain, we uncover an inverted U-shaped relationship between firm destruction and total factor productivity (TFP) growth: at low levels of firm exit, Schumpeterian cleansing effects dominate and the effect of firm destruction on TFP is positive, but when exit rates are very high, this effect turns negative. In order to rationalize this finding, we build on Asturias et al. (2017) and develop a model of firm dynamics with exit spillovers calibrated to match the non-linearity found in the data. This reduced-form spillover captures amplification effects from very high destruction rates that might force viable firms to exit, for example, due to disruptions in the production network and a generalised contraction in credit supply. Armed with the calibrated model, we perform counterfactual scenarios depending on the severity of the shock to firm exit. We find that when the shock is mild and firm destruction rates upon impact are similar to those observed during the Global Financial Crisis (GFC), TFP growth increases, and the recovery is faster. However, when the shock is severe and firm exit is well above that of the GFC, TFP growth decreases, since high efficiency firms are forced out of the market, which makes the recovery much slower. Overall, our results point to the importance of keeping exit rates low to avoid long term scarring effects.