Loan Guarantees in a Democracy

Abstract

We study the political economy of loan guarantees within a credit-rationing framework. In this framework, a government uses guarantees to decrease the borrowing cost, thus making more households incentive compatible. This shifts capital to productive projects (allocative effect). Backed by taxpayers, loan guarantees also shift consumption from non-borrowers to borrowers (redistributive effect). While a welfare-maximizing planner is only concerned about the allocative effect, voteshare-maximizing politicians' decision is driven by both effects. We show that even when the majority is formed by borrowers, who are the beneficiaries of the redistributive effect, the allocative effect reins in the generosity of guarantees.

Keywords: loan guarantees, redistributive effect, allocative effect, voting JEL Classification: D72, G28

JEL Classification: D72, G18