A Proposal to Eliminate the Distortions Caused by Bailouts

V. V. Chari & Patrick J. Kehoe

January 2016 | Federal Reserve Bank of Minneapolis Economic Policy Paper 16-1

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.