Many business sectors and households face an unprecedented loss of income in the current COVID-19 recession, triggering financial distress, separations, and bankruptcy. Rather than stimulating demand, government policy’s main aim should be to provide insurance to firms and workers to avoid undue scarring that will hamper a recovery once the pandemic is past. We develop a corporate finance framework to guide interventions in credit markets to avoid such scarring. We emphasize three main results. First, policy should inject liquidity into small and medium-sized firms that are liquidity constrained and for which social costs of bankruptcy are high. Second, large firms for whom solvency is the dominant issue require a more nuanced approach. Debt overhang creates a distortion, leading these firms to fire workers, forgo expenditures that maintain enterprise value, and delay filing for a Chapter 11 bankruptcy longer than is socially efficient. Government resources toward reducing the legal and financial costs of bankruptcy are unambiguously beneficial. Policies that reduce funding costs are only socially desirable if the pandemic is expected to be short-lived and if bankruptcy costs are high. Last, transfers necessary to avoid bankruptcy allow borrowers to continue paying their mortgages or credit card bills and ultimately benefit owners of assets such as real estate or credit card receivables. Taxes to fund transfers should be raised from these asset owners.
All Science Journal Classification (ASJC) codes
- Business, Management and Accounting(all)
- Economics and Econometrics