Asymmetric Information, Government Credit Subsidy, and Economic Growth

We develop a model in which asymmetric information gives rise to both problems of adverse selection and costly state verification. Under the separating equilibrium in the credit market, some borrowers are credit rationed. We consider three types of government subsidies: interest rate subsidy, loan guarantees, and monitoring cost subsidy. We find that all of these three tax-financed government credit programs are able to alleviate the problem of asymmetric information and decrease the incidence of credit rationing, whereas the resulting taxation exacerbates the credit market distortions due to asymmetric information and crowds out capital investment by reducing the supply of loanable funds. In other words, government credit programs generate a tradeoff between two opposing effects on capital investment and economic growth: They improve the efficiency of the credit market in channeling funds from lenders to borrowers by reducing the incidence of credit rationing on the one hand, but lead to a higher distortionary taxation on the production activities on the other. We study the above tradeoff and characterize the optimal subsidy ratio under the different subsidy programs from both the growth and welfare perspectives. Among other results, our simulation results under plausible parameterizations of the model show that the government loan guarantees are most efficient in ameliorating the problem of asymmetric information in the credit market among the three subsidy programs we consider. In addition, we find that, when the adverse selection among borrowers is not so severe, it may be optimal for the government to impose a tax on credit and use the proceeds to finance a subsidy on output production, i.e., the optimal ratios of government credit subsidies can be negative.