Conglomerates, Liquidity Shocks, and Innovation-Led Growth

TL;DR

This paper presents a dynamic model of conglomerate internal capital markets responding to liquidity shocks, highlighting how strategic reallocation affects innovation and growth over different development stages.

Contribution

It introduces a two-stage framework for firm reallocation decisions within conglomerates, integrating these into an endogenous growth model to analyze policy implications.

Findings

Early coercion maintains liquidity and broad innovation.

Near the frontier, strategies shift to liquidation or long-term investment.

Identifies policy failures: coercion trap and liquidation fallacy.

Abstract

I develop a dynamic model of how internal capital markets in conglomerates respond to liquidity shocks when affiliated firms vary in innovation potential. A two-stage framework defines cutoff rules for when the conglomerate should liquidate low-productivity firms, coerce intermediate types into short-termist strategies, or preserve high-potential firms for long-horizon R&D. Embedding these margins into an endogenous growth model, I show how the optimal policy evolves: early in development, coercion preserves liquidity while sustaining broad innovation; as the economy nears the frontier and short-term returns decline, the optimal strategy shifts toward binary reallocation between liquidation and long-termism. I characterize two policy failures: a "coercion trap," where short-termism persists too long, and a "liquidation fallacy," where viable firms are discarded prematurely. The framework provides microfoundations for dynamic reallocation in conglomerate systems and offers policy insights for crisis-era restructuring.