Fed Paper: Strategic Default Explains a Third of TFP Cycles

The mechanism works through the channel of credit allocation. In a boom, lenders fund the most productive firms. When conditions sour, information asymmetries make credit harder to distinguish between good and bad borrowers. Some productive firms get squeezed, while less efficient ones survive by rolling over debt. The share of output from low-productivity firms rises, pulling down the aggregate.

This matches the empirical pattern the authors document: productivity dispersion across firms in the same industry rises during recessions. The gap between the top and bottom firms in measured output per unit of input widens. Standard models that treat productivity as purely exogenous cannot replicate that widening.

The finding has implications for how economists think about potential output. If a recession permanently scars TFP by shifting the distribution of firms toward less productive ones, the recovery may need a repair of credit markets – not just demand stimulus – to bring the pre-crisis productivity trend back.

The paper, published as FEDS Working Paper 2026-047, is available at the Federal Reserve Board's website. The authors note the research is preliminary and does not reflect Board views.