Well-intended policies

Market failures provide a rationale for policy intervention. But policies are often hard to alter once in place. We argue that this inertia can result in well-intended policies having sizable negative long-run effects on aggregate output and productivity. In our theory, financial frictions provide a rationale for providing subsidized credit to productive entrepreneurs to alleviate the credit constraints they face. In the short run, such targeted subsidies have the intended effect and raise aggregate output and productivity. In the long run, however, individual productivities mean-revert while individual-specific subsidies remain fixed. As a result, entry into entrepreneurship is distorted: The subsidies prop up entrepreneurs that were formerly productive but are now unproductive, while impeding the entry of newly productive individuals. Therefore aggregate output and productivity are depressed. Our theory provides an explanation for two empirical observations on developing countries: idiosyncratic distortions that disproportionately affect productive establishments, and temporary growth miracles followed by growth failures.