Credit Guarantee and Fiscal Costs

Abstract

This paper studies the effectiveness of government-backed credit guarantees to the infrastructure sector, a policy tool adopted by a range of countries during recessions. We propose a two-sector model with financial intermediary frictions so that infrastructure producers rely on bank loans to finance their risky production. Governments can intervene in the credit market by providing a partial guarantee on those bank loans. We find that a credit guarantee increases infrastructure production, leading to a high fiscal multiplier in the longer run. In the near term, however, higher wages in the infrastructure sector crowd out labor supply in the private sector, dampening economic activity. Importantly, the higher leverage associated with credit expansion raises non-performing loans, and this channel is particularly pronounced if the government-backed credit guarantee lingers for a long period of time.

Keywords: Fiscal multiplier, credit guarantee, bailout policy, financial friction

JEL Classification: E62, E44