A0827
Title: Defaultable credit in an input-output economy
Authors: Khalil Esmkhani - Simon Fraser University (Canada) [presenting]
Ali Karimirad - University of Washington (United States)
Abstract: Debt financing is crucial for business operations but creates distortions when defaults are possible. The focus is on how defaultable credit affects resource allocation using a multi-sector input-output model with endogenous defaults. Limited enforcement of debt contracts induces persistent economic distortions through over-ordering of intermediate inputs and excessive credit demand. Distortions accumulate upstream, with sectors producing intermediate inputs acting as sinkholes that overproduce, while downstream sectors producing final goods underproduce. This misallocation directs excessive resources toward intermediate inputs at the expense of final goods, reducing total factor productivity, consumption, and welfare. The inefficiency stems from incomplete credit contracts where parties consider only non-defaulting scenarios, generating pecuniary externalities they fail to internalize. Default possibilities also skew debt structure toward senior debts like trade credit, further enhanced by flexible factors of production. Using US data, these distortions are demonstrated to be economically significant.
