Support for Small Businesses Amid COVID-19

48 Pages Posted: 10 Jul 2020

See all articles by Charles Goodhart

Charles Goodhart

London School of Economics & Political Science (LSE) - Financial Markets Group

Dimitrios P. Tsomocos

University of Oxford - Said Business School and St. Edmund Hall

Xuan Wang

VU University Amsterdam; Tinbergen Institute

Multiple version iconThere are 3 versions of this paper

Date Written: July 8, 2020

Abstract

A sizeable proportion of enterprises, especially SMEs, in receipt of financial assistance from 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 deter those mostly likely to fail to repay from seeking such financial assistance in the first place. The answer largely turns on the relative weights attached for the objectives of stabilisation as compared with allocative efficiency. For this purpose, we develop a two-sector infinite horizon model featuring oligopolistic small businesses and a screening contract in the presence of a pandemic shock with asymmetric information. The adversely affected sector with private information can apply for government loans to reopen businesses once the pandemic has passed. First, we show that a pro-allocation government sets a harsh default sanction to deter entrepreneurs with bad projects from reentering and improves aggregate productivity in the long run, but the economy suffers persistent unemployment in the near term. However, a pro-stabilisation government sets a lenient default sanction or provides full guarantees to reach full employment in the short term, but the economy will be shifted to a lower equilibrium in the long run. The optimal default sanction balances the trade-off between allocation and stabilisation. Then, we derive an analytic measure of "Stabilisation Proclivity" and characterise the parameter space and the macro-financial frictions that render the government either more pro-allocation or more pro-stabilisation. Finally, we solve for the optimal default sanction numerically and conducts comparative statics for various policy analyses.

Keywords: COVID-19, government guarantees, optimal default sanction, unemployment, productivity, adverse selection, private information, screening

JEL Classification: D82, E44, G38, H81

Suggested Citation

Goodhart, Charles A.E. and Tsomocos, Dimitrios P. and Wang, Xuan, Support for Small Businesses Amid COVID-19 (July 8, 2020). Available at SSRN: https://ssrn.com/abstract=3646495 or http://dx.doi.org/10.2139/ssrn.3646495

Charles A.E. Goodhart

London School of Economics & Political Science (LSE) - Financial Markets Group ( email )

Houghton Street
London WC2A 2AE
United Kingdom
0207 955 7555 (Phone)
0207 242 1006 (Fax)

Dimitrios P. Tsomocos

University of Oxford - Said Business School and St. Edmund Hall ( email )

Park End Street
Oxford, OX1 1HP
Great Britain
+44 1865 288 932 (Phone)
+44 1865 288 805 (Fax)

Xuan Wang (Contact Author)

VU University Amsterdam ( email )

De Boelelaan 1105
Amsterdam, ND North Holland 1081 HV
Netherlands

HOME PAGE: http://https://sites.google.com/view/xuan-wang

Tinbergen Institute ( email )

Gustav Mahlerplein 117
Amsterdam, 1082 MS
Netherlands

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