TY  - JOUR
AU  - Chari, V.V.
AU  - Kehoe, Patrick J
TI  - Bailouts, Time Inconsistency, and Optimal Regulation
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 19192
PY  - 2013
Y2  - June 2013
DO  - 10.3386/w19192
UR  - http://www.nber.org/papers/w19192
L1  - http://www.nber.org/papers/w19192.pdf
N1  - Author contact info:
Varadarajan V. Chari
Department of Economics
University of Minnesota
1035 Heller Hall
271 - 19th Avenue South
Minneapolis, MN 55455
Tel: 612/626-5171
Fax: (612) 624-0209
E-Mail: varadarajanvchari@gmail.com

Patrick J. Kehoe
Department of Economics
Stanford University
579 Jane Stanford Way
Stanford, CA 94305
E-Mail: patrickjameskehoe@gmail.com
AB  - We develop a model in which, in order to provide managerial incentives, it is optimal to have costly bankruptcy. If benevolent governments can commit to their policies, it is optimal not to interfere with private contracts. Such policies are time inconsistent in the sense that, without commitment, governments have incentives to bail out firms by buying up the debt of distressed firms and renegotiating their contracts with managers. From an ex ante perspective, however, such bailouts are costly because they worsen incentives and thereby reduce welfare. We show that regulation in the form of limits on the debt-to-value ratio of firms mitigates the time-inconsistency problem by eliminating the incentives of governments to undertake bailouts. In terms of the cyclical properties of regulation, we show that regulation should be tightest in aggregate states in which resources lost to bankruptcy in the equilibrium without a government are largest.
ER  -