A Proposal to Eliminate the Distortions Caused by Bailouts

Varadarajan Chari and Patrick Kehoe

No 16-1, Economic Policy Paper from Federal Reserve Bank of Minneapolis

Abstract: We argue that bailouts create tax distortions, subsidy distortions and debt-size externalities. We show that an orderly resolution provision as in the Dodd-Frank Act addresses the tax and subsidy distortions but not the debt-size externalities. A regulatory system that imposes limits on the debt-equity ratio of firms and imposes a Pigouvian tax on their size eliminates the distortions and completely corrects the externalities.

Pages: 6 pages
Date: 2016-01-05
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