How Good Are Standard Debt Contracts? Stochastic versus Nonstochastic Monitoring in a Costly State Verification Environment.

The authors investigate ex ante efficient contracts in an environment in which implementation is costless. In this environment, standard debt contracts will typically not be optimal. Optimal contracts may involve defaults even in states in which the borrower is fully able to repay. The authors then examine the welfare costs of arbitrarily restricting the set of feasible contracts to standard debt contracts. When model parameters are calibrated to realistic values, the welfare loss from exogenously imposing this restriction is extremely small. Thus, if implementation costs are actually nontrivial (as seems likely), standard debt contracts will be (very close to) optimal. Copyright 1994 by University of Chicago Press.