Support for small businesses amid COVID-19

Charles A.E. Goodhart, Dimitrios P. Tsomocos, Xuan Wang*

*Corresponding author for this work

Research output: Contribution to JournalArticleAcademicpeer-review

Abstract

How should the government support small and medium-sized enterprises amid a pandemic crisis while balancing the trade-off between short-run stabilization and long-run allocative efficiency? We develop a two-sector equilibrium model featuring small businesses with private information on their likely future success and a screening contract. Businesses in the sector adversely affected by a pandemic can apply for government loans to stay afloat. A pro-allocation government sets a harsh default sanction to deter entrepreneurs with poorer projects, thereby improving long-run productivity at the cost of persistent unemployment, whereas a pro-stabilization government sets a lenient default sanction. Interest rate effective lower bound leads to involuntary unemployment in the other open sector and shifts the optimal default sanction to a lenient stance. The rise in firm markups exerts the opposite effect. A high creative destruction wedge polarizes the government's hawkish and dovish stances, and optimal default sanction is more lenient, exacerbating resource misallocation. The model illuminates how credit guarantees might be structured in future crises.

Original languageEnglish
Pages (from-to)612-652
Number of pages41
JournalEconomica
Volume90
Issue number358
DOIs
Publication statusPublished - Apr 2023

Bibliographical note

Funding Information:
We thank the editor and three anonymous referees for exceptionally thorough and helpful comments. We thank Venky Venkateswaran, Lukas Vogel, Benjamin Born, Alexander Rodnyansky, Juuso Vanhala, Remco Zwinkels, Tim Eisert, Rex Wang, and seminar participants at the 2022 American Economic Association Meetings, 2022 Second Finance and Productivity Conference (CompNet, EBRD, IWH), 2021 Annual Congress of the European Economic Association, the European Commission Directorate General for Economic and Financial Affairs, the 2020 European Winter Meetings of the Econometric Society, the 2021 Midwest Finance Association Annual Conference, the 2021 Royal Economic Society Annual Conference, the 2020 Dutch Economists Week, Vrije Universiteit Amsterdam Finance Seminars, Rotterdam School of Management Seminar Series, and School of Banking and Finance seminar of the University of International Business and Economics for valuable comments.

Publisher Copyright:
© 2023 The Authors. Economica published by John Wiley & Sons Ltd on behalf of London School of Economics and Political Science.

Funding

We thank the editor and three anonymous referees for exceptionally thorough and helpful comments. We thank Venky Venkateswaran, Lukas Vogel, Benjamin Born, Alexander Rodnyansky, Juuso Vanhala, Remco Zwinkels, Tim Eisert, Rex Wang, and seminar participants at the 2022 American Economic Association Meetings, 2022 Second Finance and Productivity Conference (CompNet, EBRD, IWH), 2021 Annual Congress of the European Economic Association, the European Commission Directorate General for Economic and Financial Affairs, the 2020 European Winter Meetings of the Econometric Society, the 2021 Midwest Finance Association Annual Conference, the 2021 Royal Economic Society Annual Conference, the 2020 Dutch Economists Week, Vrije Universiteit Amsterdam Finance Seminars, Rotterdam School of Management Seminar Series, and School of Banking and Finance seminar of the University of International Business and Economics for valuable comments.

Keywords

  • Credit guarantees
  • optimal default sanction
  • allocative efficiency
  • adverse selection
  • screening

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