The Politician and his Banker – How to Efficiently Grant State Aid

In the current recession, politicians grant state aid of yet unknown dimensions. But what is the most efficient measure for granting such aid? We use a theoretical model with firms that differ in their creditworthiness and compare different types of direct subsidies with indirectly subsidized loans. We find that, in a large parameter range, politicians prefer subsidized loans to direct subsidies, because these avoid windfall gains to entrepreneurs, and they economize on screening costs. For similar reasons, subsidized loans may increase social welfare relative to subsidies. From a welfare perspective, politicians use subsidized loans inefficiently often.