Firm Quality Dynamics and the Slippery Slope of Credit Intervention

In crises, low-quality firms face greater financial shortfalls and invest less than high-quality firms. Public liquidity support preserves the overall production capacity but dampens the cleansing effects of crises on firm quality. The trade-off between quantity and quality determines the optimal size of intervention. Policy distortions are self-perpetuating: A downward bias in quality necessitates interventions of greater scales in future crises. Distortions are amplified by low-quality firms’ expectations of liquidity support and overinvestment pre-crisis. Finally, the optimal intervention is larger and distortionary effects stronger in a low interest rate environment where low yields on precautionary savings discourage firms from self-insurance.