Financial Sector Inefficiencies and the Debt Laffer Curve

Abstract

Agénor and Aizenman analyze the implications of inefficient financial intermediation for debt management using a model in which firms rely on bank credit to finance their working capital needs and lenders face high state verification and enforcement costs of loan contracts. Their analysis shows that lower expected productivity, higher contract enforcement and verification costs, or higher volatility of productivity shocks may shift the economy to the wrong side of the debt Laffer curve, with potentially sizable output and welfare losses. The main implication of this analysis is that debt relief may generate little welfare gains unless it is accompanied by reforms aimed at reducing financial sector inefficiencies.

This paper - a product of the Economic Policy and Poverty Reduction Division, World Bank Institute - is part of a larger effort in the institute to understand the macroeconomic effects of financial sector inefficiencies.