Credit and Efficiency in Centralized and Decentralized Economies

Abstract

We study a credit model where, because of adverse selection, unprofitable projects may nevertheless be financed. Indeed they may continue to be financed even when shown to be lowquality if sunk costs have already been incurred. We show that credit decentralization offers a way for creditors to commit not to refinance such projects, thereby discouraging entrepreneurs from undertaking them initially. Thus, decentralization provides financial discipline. Nevertheless, we argue that it puts too high a premium on short-term returns. The model seems pertinent to two issues: "soft budget constraint" problems in centralized economies, and differences between "Anglo-Saxon" and "German-Japanese" financing practices.

Federal tax-transfer policy and intergovernmental pre-commitment

“…Therein, a pre-commitment by states enables an efficient local policy if the federal government provides transfers so as to equalize private consumption across states. 11 The current analysis differs from the contribution by adopting a fiscal arrangement in which the public good is only locally consumed, the federal government is concerned about the allocation of public consumption across states, and both levels of government levy distortionary taxes.…”

“…12 Formally elaborated by Dewatripont and Maskin (1995), a missing commitment ability by the government lies at the root of the soft budget constraint phenomenon. Enterprises form expectations that they will be bailed-out in case of insolvency which results in sub-optimal investment choices.…”

Why do financial systems differ? History matters

“…It can store deposits on behalf of lenders during the period with a net return normalized to zero. 8 It can also lend funds to borrowers. In that case, the bank incurs a cost ρ t ≥ 0 for each unit of good it lends to borrowers at date t, and discovers whether each project is good or bad at the end of the first stage of production.…”

“…A contract between the borrower and the bank stipulates a transfer x 1 ≤ R from the 8 Alternatively, we could assume that the bank has access to a foreign capital market where a one period risk-free security pays zero interest. more likely to be good projects.…”

The politician and his banker — How to efficiently grant state aid

“…They also have positive effects on the financial system by contributing to its stability (Allen and Gale, 2004;Andrianova, Demetriades, and Shortland, 2008). It might happen that public banks operate with a soft budget constraint because the government cannot commit to not refinancing poorly performing public banks (Kornai, 1980;Dewatripont and Maskin, 1995). Empirical evidence with respect to the efficiency of public banks is mixed.…”