Financial sector inefficiencies and the debt Laffer curve

This paper analyses the implications of inefficient financial intermediation for debt management in a model where firms rely on bank credit to finance their working capital needs and lenders face state verification and contract enforcement costs. We show that lower expected productivity, higher enforcement and verification costs, or higher volatility of productivity shocks, may shift a country to the wrong side of its debt Laffer curve, with potentially sizable output and welfare losses. We also show that debt relief may bring few welfare benefits unless it is accompanied by reforms aimed at reducing financial sector inefficiencies. Copyright (C) 2005 John Wiley Sons, Ltd.