Working Paper: NBER ID: w19192
Authors: VV Chari; Patrick J. Kehoe
Abstract: We develop a model in which, in order to provide managerial incentives, it is optimal to have costly bankruptcy. If benevolent governments can commit to their policies, it is optimal not to interfere with private contracts. Such policies are time inconsistent in the sense that, without commitment, governments have incentives to bail out firms by buying up the debt of distressed firms and renegotiating their contracts with managers. From an ex ante perspective, however, such bailouts are costly because they worsen incentives and thereby reduce welfare. We show that regulation in the form of limits on the debt-to-value ratio of firms mitigates the time-inconsistency problem by eliminating the incentives of governments to undertake bailouts. In terms of the cyclical properties of regulation, we show that regulation should be tightest in aggregate states in which resources lost to bankruptcy in the equilibrium without a government are largest.
Keywords: Bailouts; Time Inconsistency; Optimal Regulation
JEL Codes: E0; E44; E6; E61
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Lack of government commitment (H11) | Incentives to bail out firms (G28) |
| Incentives to bail out firms (G28) | Reduced managerial effort (M54) |
| Reduced managerial effort (M54) | Decreased welfare (I38) |
| Regulation (L51) | Reduced incentives for bailouts (G28) |
| Reduced incentives for bailouts (G28) | Improved welfare (I39) |
| Regulation should be tightest in economic states where losses from bankruptcy are greatest (G33) | Improved welfare (I39) |
| Lack of government commitment (H11) | Inefficient outcomes (D61) |