Working Paper: CEPR ID: DP15055
Authors: Charles A. Goodhart; Dimitrios P. Tsomocos; Xuan Wang
Abstract: A sizeable proportion of enterprises, especially SMEs, in receipt of financial assistancefrom the government, will fail to repay. In this paper we asked whether,and to what extent, it may be beneficial to apply a screening mechanism to deterthose mostly likely to fail to repay from seeking such financial assistance in thefirst place. The answer largely turns on the relative weights attached for the objectivesof stabilisation as compared with allocative efficiency. For this purpose, wedevelop a two-sector infinite horizon model featuring oligopolistic small businessesand a screening contract in the presence of a pandemic shock with asymmetric information.The adversely affected sector with private information can apply forgovernment loans to reopen businesses once the pandemic has passed. First, weshow that a pro-allocation government sets a harsh default sanction to deter entrepreneurswith bad projects from reentering and improves aggregate productivityin the long run, but the economy suffers persistent unemployment in the near term.However, a pro-stabilisation government sets a lenient default sanction or providesfull guarantees to reach full employment in the short term, but the economy willbe shifted to a lower equilibrium in the long run. The optimal default sanction balancesthe trade-off between allocation and stabilisation. Then, we derive an analyticmeasure of “Stabilisation Proclivity” and characterise the parameter space and themacro-financial frictions that render the government either more pro-allocation ormore pro-stabilisation. Finally, we solve for the optimal default sanction numericallyand conducts comparative statics for various policy analyses.
Keywords: COVID-19; government guarantees; optimal default sanction; unemployment; productivity; adverse selection; private information; screening
JEL Codes: D82; E44; G38; H81
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| pro-allocation government (harsh default sanctions) (P26) | aggregate productivity (E23) |
| pro-allocation government (harsh default sanctions) (P26) | persistent unemployment (J64) |
| pro-stabilization government (lenient default sanctions) (E63) | full employment (short term) (J23) |
| pro-stabilization government (lenient default sanctions) (E63) | lower long-run equilibrium (D59) |
| optimal default sanction (intermediate) (K49) | balance between allocation and stabilization (E63) |