Economic policy reform, government debt guarantees, and financial bailouts

Economic policy reform that creates opportunities for new productive activities often shifts wealth from one set of agents toward another, creating reason for political pressure against the reform. The author explores how government financial guarantees secure the political support of the reform's"losers."Governnment guarantees have two effects: 1) they will probably lead to a bailout of some firms'obligations to debtholders. This bailout must be financed by taxes on the cash flows from old and new projects, and tax collection involves a resource cost; 2) the existence of the guarantees distorts entrepreneurs'investment incentives by creating an incentive to invest in overly risky projects and not to invest in safe new projects. The author demonstrates that government guarantees on existing debt, combined with the use of junior secured debt to finance new projects, would mitigate the problem of underinvestment in safe projects and overinvestment in risky projects. The potentially positive role of government financial guarantees after economic reform does not imply that prudential banking standards fail to apply during a period of economic reform. If anything, prudential standards are more important during such a period. But it does imply that a financial bailout may be a lagging indicator of a successful policy to offer financial guarantees to potential losers, so they will support reform.