External Finance and the Real Economy

Abstract

In this paper we explore the possibility that external finance has benefits over internal finance in a world where reallocation of funds across firms is important. In the model, outside investors (the external financiers) have an excessive tendency to liquidate existing investment projects, since they get the full benefits from liquidation but only partial benefits from continuation of existing projects. Excessive liquidation is inefficient for firms individually, but it may have social benefits if the efficient allocation of resources requires funds to be reallocated across firms. Excessive liquidation increases the supply of funds in the reallocation market and makes this market deeper in the sense that it becomes easier for firms to raise capital. In anticipation of this deep market, firms invest more in information acquisition. This information acquisition increases overall productivity since it allows capital to flow to the most productive projects. Thus, a need for external finance may actually improve the equilibrium allocation of the economy. The model generates comparative statics' results as the degree of pledgeability of cash flows (which can be proxied, for example, by the degree of investor protection) and the need for external finance change. For example, the model predicts that measures of external finance will be positively correlated with the availability of information about firms.