Dysfunctional Finance : Positive Shocks and Negative Outcomes
This paper shows how badly a market economy may respond to a positive productivity shock in an environment with asymmetric information about project quality: some, all, or even more than all the benefits from the increase in productivity may be dis...
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| Format: | Policy Research Working Paper |
| Language: | English |
| Published: |
2012
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| Subjects: | |
| Online Access: | http://www-wds.worldbank.org/external/default/main?menuPK=64187510&pagePK=64193027&piPK=64187937&theSitePK=523679&menuPK=64187510&searchMenuPK=64187283&siteName=WDS&entityID=000333038_20100203233222 http://hdl.handle.net/10986/3701 |
| Summary: | This paper shows how badly a market
economy may respond to a positive productivity shock in an
environment with asymmetric information about project
quality: some, all, or even more than all the benefits from
the increase in productivity may be dissipated. In the
model, based on Bernanke and Gertler (1990), entrepreneurs
with a low default probability are charged the same interest
rate as entrepreneurs with a high default probability. The
implicit subsidy from good types to bad means that the
marginal entrant will have a negative-value project. An
example is presented in which, after a positive productivity
shock, the presence of enough bad type's forces the
interest rate so high that it drives all entrepreneurs out
of the market. This happens in an industry in which there
are good projects that are productive. The problem is that
they are contaminated in the capital market by bad projects
because of the banks inability to distinguish good projects
from bad. One possible explanation for the lack of
development in some countries is that screening institutions
are sufficiently weak that impersonal financial markets
cannot function. If industrialization entails learning
spillovers concentrated within national boundaries, and if
initially informational asymmetries are sufficiently great
that the capital market does not emerge, then neither
industrialization nor the learning that it would foster will occur. |
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