Optimal Financing Contracts, Investor Protection, and Growth

Recent empirical evidence has suggested a positive association between various measures of investor protection and financial market development, and between financial market development and economic growth. We introduce investor protection in a simple extension of the two-period overlapping generations model of capital accumulation. We use such structure in order to develop predictions for the effects of investor protection on economic growth. Young individuals (entrepreneurs) are endowed with investment projects that need to be financed by outside investors. The quality of each project is random and unknown at the time of financing. Ex-post, once production is carried out, entrepreneurs observe their cash-flows, but financiers do not. Thus agents have an incentive to misreport their cash-flows and appropriate part of them. We capture the degree of investor protection as the extent to which this appropriation is possible. For a closed economy, our results show that, contrary to conventional wisdom, better investor protection is generally detrimental to capital accumulation and economic growth. The standard argument says that if investors are risk-averse, better investor protection results in larger demand for capital. In addition to this effect, we show that the aggregate supply of capital decreases with better investor protection, and we find that this second effect generally dominates the first. With international capital mobility, instead, better investor protection does promote financial market development and output growth. The key mechanism is an increase in the net inflow of capital from abroad, suggesting a specific channel through which investor protection affects the economy.