Volatility and growth: Credit constraints and the composition of investment
GAICIL Insights
Two economies can invest the same total amount through a recession and end up with very different futures. Volatility and growth: Credit constraints and the composition of investment, by Philippe Aghion, George-Marios Angeletos, Abhijit Banerjee and Kalina Manova, explains why.1 Volatility and growth are linked, and the mechanism runs through the composition of investment. The authors ask how uncertainty and credit constraints affect its cyclical composition, and thereby volatility and growth, identifying a novel propagation mechanism.
In the model, firms make two types of investment: a short-term one and a long-term one contributing more to productivity growth. Because long-term investment takes longer to complete, its return is less cyclical and it carries higher liquidity risk. The first property makes the long-term share countercyclical under perfect financial markets: firms shift toward long-term investment in downturns, when the opportunity cost is low. The second implies the share may turn procyclical under tight credit constraints, because liquidity risk makes long-term projects vulnerable when funding dries up. The long project is the first casualty when the cash runs short.
The consequences are significant. Through the cyclical composition of investment, tighter credit can produce both higher volatility and lower mean growth. Credit frictions do this even though they seem to have no effect on how shocks affect aggregate saving and investment. The damage lies in composition. Evidence from a panel of countries supports the key predictions. The headline investment number can look healthy while the growth engine starves.
The insight is subtle and powerful. Aggregate investment may look similar across economies with different financial systems, yet composition can differ greatly. Where credit is constrained, long-term, growth-enhancing investment is cut in downturns, lowering growth and amplifying volatility. Financial development matters for growth through this compositional channel.
Artificial intelligence investment is the archetype of the vulnerable category. AI projects often take years to complete, carry substantial liquidity risk and generate returns far in the future. In credit-constrained environments, such investment will be cut in downturns, lowering growth. Economies with deeper financial markets may sustain AI investment through the cycle more effectively. The AI race may be decided partly by whose financial system holds its nerve in a recession.
Procyclical long-term investment is a warning for AI-intensive economies. Recessions could disproportionately harm AI projects, causing lasting productivity losses. Easing credit constraints in downturns, or providing stable funding for long-term research, could protect AI investment and its growth payoff.
Aggregates can mislead policy evaluation. Macroeconomic policies stabilizing aggregate investment may not protect long-term investment if credit constraints bind. Policymakers focused on growth should watch investment composition, especially the share devoted to long-term innovation. A stabilization package that keeps short-term spending flowing and lets research collapse has missed its target.
Financial development is growth policy. Deeper markets reduce credit constraints, letting firms keep long-term investment going through the cycle. For AI, instruments that fund long-term projects with uncertain returns, such as venture capital and patient equity, sustain the investment driving innovation.
Firms can protect themselves. Holding liquidity or securing committed credit lines reduces the risk that long-term projects must be abandoned when funding tightens, a consideration for AI programs with long development horizons. Prudence on the balance sheet is ambition protected.
The double penalty is the broad stake. Economies with tighter credit constraints face lower growth and higher volatility at once. Improving financial access can reduce both, producing steadier and faster growth, especially valuable as economies shift toward AI-intensive production.
Taken together, credit constraints shape growth through investment composition. Long-term, growth-enhancing investment becomes procyclical when credit is tight, raising volatility and lowering growth. As AI investment becomes central to productivity, financial systems that sustain long-term investment through downturns will be essential for capturing the technology's growth potential.
Here is the uncomfortable test for macro policymakers: track the share of long-horizon investment, including AI research, as a headline indicator alongside total investment. An economy can meet every aggregate target in a downturn while quietly abandoning the projects that would have powered the next decade.
Introduction
How does uncertainty and credit constraints affect the cyclical composition of investment and thereby volatility and growth? This paper addresses this question within a model where firms engage in two types of investment: a short-term one; and a long-term one, which contributes more to productivity growth. Because it takes longer to complete, long-term investment has a relatively less cyclical return; but it also has a higher liquidity risk. The first effect ensures that the share of long-term investment to total investment is countercyclical when financial markets are perfect; the second implies that this share may turn procyclical when firms face tight credit constraints. A novel propagation mechanism thus emerges: through its effect on the cyclical composition of investment, tighter credit can lead to both higher volatility and lower mean growth. Evidence from a panel of countries provides support for the model's key predictions.
Takeaway
This paper identified a novel propagation mechanism in the impact of credit frictions on the cyclical composition of investment. We first showed how the share of long-term investment turns from countercyclical under complete markets to procyclical under sufficiently tight credit constraints. We then showed how through this channel credit frictions can lead to both lower mean growth and amplified volatility, even though they seem to have no effect on the impact of shocks on aggregate saving and investment. We finally provided some supporting empirical evidence.1
Needless to say, both the theoretical and the empirical lessons of this paper have their limitations. Also, any careful quantitative assessment would require that our mechanism be embedded within a more standard business-cycle model—an exercise that we leave for future research. We nevertheless hope that our findings may draw more attention to the important interaction between credit constraints and the composition of investment, and the implications of this interaction for short-run fluctuations and long-run growth. Largely motivated by our findings, Aghion, Bacchetta, Ranciere and Rogoff (2006) proceed to investigate the relationship between growth and exchange-rate volatility, while Aghion, Hemous, and Kharroubi (2009) look at the relationship between growth and the cyclicality of fiscal policy. The former paper finds that exchange-rate volatility has a stronger negative effect on growth in countries with tighter credit, while the latter paper finds that countercyclical fiscal policy has a stronger positive effect on growth in industries with higher financial dependence within countries with tighter credit. Finally, using a panel of French firms, Aghion et al. (2008) find that the share of R&D investment—another natural measure of long-term investments—is more procyclical in firms that face tighter credit constraints. Combined, this subsequent work complements the contribution of our paper and further highlights the value of investigating the joint determination of the composition of investment, short-run volatility, and long-run growth.
Notes
- Philippe Aghion et al., Volatility and growth: Credit constraints and the composition of investment, 57 J. Monetary Econ. 246 (2010), https://doi.org/10.1016/j.jmoneco.2010.02.005. Takeaway source: Concluding remarks, reproduced from a free author or repository copy. ↩
Cite as: Philippe Aghion et al., Volatility and growth: Credit constraints and the composition of investment, 57 J. Monetary Econ. 246 (2010), https://doi.org/10.1016/j.jmoneco.2010.02.005
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