Credit Misallocation and Inflation in Europe
The European economy has been recently characterized by near-zero inflation and an extraordinarily accommodative monetary policy. Motivated by this evidence, we show that, in an environment with poorly capitalized banks, low policy rates can have a negative effect on inflation. In a stylized model, we show that low policy rates help low-capital banks extend extra credit to weak firms in order to prevent them from defaulting (“zombie” lending). The resulting low firm default rate increases competition that, in turn, has a negative effect on product prices. We test our mechanism exploiting firm-level data from twelve European countries. After confirming that subsidized credit to weak firms has dramatically increased since 2012, we find that, in the cross-section of industries and countries, an increase in the share of zombie firms is associated with a decrease of markups, prices, and firm entries and defaults, while aggregate sales increase. Our results hold at the firm-level and are stronger for non-tradable products, more affected by local credit markets.
Dr Chau Chak Wing Building
