Support for small businesses amid COVID‐19

How should the government support small and medium-sized enterprises amid a pandemic crisis while balancing the trade-off between short-run stabilization and long-run allocative efficiency? We develop a two-sector equilibrium model featuring small businesses with private information on their likely future success and a screening contract. Businesses in the sector adversely affected by a pandemic can apply for government loans to stay afloat. A pro-allocation government sets a harsh default sanction to deter entrepreneurs with poorer projects, thereby improving long-run productivity at the cost of persistent unemployment, whereas a pro-stabilization government sets a lenient default sanction. Interest rate effective lower bound leads to involuntary unemployment in the other open sector and shifts the optimal default sanction to a lenient stance. The rise in firm markups exerts the opposite effect. A high creative destruction wedge polarizes the government’s hawkish and dovish stances, and optimal default sanction is more lenient, exacerbating resource misallocation. The model illuminates how credit guarantees might be structured in future crises.