Despite the cogent criticism that "bailing out" insolvent firms creates moral hazard, bailouts often occur in the aftermath of bank runs and other financial crises. In an environment where it is economically efficient to make illiquid investments, and where investors have private information regarding their respective liquidity risks, the investment contract must satisfy an incentive constraint. Limited liability tightens this constraint under laissez faire. In principle, government bailouts of insolvent firms might undo this adverse effect of limited liability. A theoretical example is constructed in which bailing out an insolvent corporate sector in some states of the world is essential to implementing efficient investment in a limited-liability regime. This example illustrates the beneficial constraint-relaxation effect of a bailout but abstracts from the moral hazard problem against which it must be weighed.

View Full Article