The politician and his banker — How to efficiently grant state aid

Politicians should spend money as efficiently as possible. But what is the best method of granting state aid to firms? We use a theoretical model with firms that differ in their success probabilities and compare different types of direct subsidies with indirect subsidies through bank loans. We find that, for a large range of parameters, subsidies through banks entail higher social welfare than direct subsidies, avoiding windfall gains to entrepreneurs and economizing on screening costs. For selfish politicians, subsidizing a bank has the additional advantage that part of the screening costs are born by private banks. Consequently, from a welfare perspective, politicians use subsidized banks inefficiently often.

► When firms generate positive externalities, politicians want to subsidize. ► Under hidden information, politicians cannot distinguish who needs the subsidy. ► Bankers have the ability to assess firm quality, at a cost. They can generate information that politicians lack. ► The efficient form of intervention is often an indirect subsidy to firms through bank loans. ► From a welfare perspective, politicians use subsidized loans too often.