"Firm Dynamics in Spatial Equilibrium with a Competitive Credit Market"

We study the dynamic effects of business creation subsidies in an analytically tractable firm life cycle model with long-term debt, geographical variation in business idiosyncratic risk and worker mobility. Firms are initially financially constrained but after entry they have access to a perfectly competitive credit market, which gives them incentives to (over)borrow to dilute the value of past debt, at the cost of greater bankruptcy risk. We use the model to study the effects of the recent “I Stay in the South” business creation subsidy, specifically targeted to stimulate aggregate activity in the South of Italy and retain the labour force locally. Given the financial frictions, the subsidy was close to optimal. Absent financial frictions, the optimal subsidy would have been fifty percent larger: overborrowing tends to cause excessive entry, and makes the subsidy less expansionary because of higher bankruptcy rates. Both effects are amplified by the abundant cheap credit of the last decade.