Credit and Efficiency in Centralized and Decentralized Economies

We study a credit model where, because of adverse selection, unprofitable projects may nevertheless be financed. Indeed they may continue to be financed even when shown to be low-quality if sunk costs have already been incurred. We show that credit decentralization offers a way for creditors to commit not to refinance such projects, thereby discouraging entrepreneurs from undertaking them initially. Thus, decentralization provides financial discipline. Nevertheless, we argue that it puts too high a premium on short-term returns. The model seems pertinent to two issues: “soft budget constraint” problems in centralized economies, and differences between “Anglo-Saxon” and “German-Japanese” financing practices.