Zombie Credit and (Dis-) Inflation: Evidence from Europe

Abstract: We show that cheap credit to impaired firms has a disinflationary effect. By helping distressed firms to stay afloat, this ``zombie credit'' creates excess production capacity that, in turn, puts downward pressure on markups and product prices. We test this mechanism exploiting granular inflation and firm-level data from eleven European countries. In the cross-section of industries and countries, we find that a rise of zombie credit is associated with a decrease in firm defaults, average firm markups and product prices, lower investment and productivity, and an increase in aggregate sales as well as material and labor cost. Our results are stronger for prices of non-tradable products, which are more affected by local credit markets, and hold at the firm level, where we document spillover effects to healthy firms in markets with high zombie credit.