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A popular idea in policy circles holds that granting potential entrepreneurs access to formal credit markets by improving public institutions and specific regulations is an important condition for economic development. In particular, reforms allowing economic agents to formalize, and therefore gain better access to formal credit markets, should naturally lead them to invest more and increase their productivity; ultimately, the benefits of higher overall growth would ensue. Such reforms typically include strengthening property rights on land and housing and reducing burdensome registration procedures. This paper examines in a general equilibrium framework the chain of causality behind that line of thinking. It does so by modeling individual agents' decisions to become formal in relation to their access to a credit market plagued by moral hazard and examining the effect of these decisions on the size of the formal sector and the level of output. The main insight is that while better property rights and less burdensome regulations may under certain conditions facilitate agents' access to formal loans, such reforms interact with the characteristics of the credit market and its environment in ways that crucially shape the ultimate magnitude of the effect on formality and output.In a nutshell, the modeling strategy relies on an overlapping-generations model where economic agents, when young, undertake productive projects, deciding whether to work in the formal or informal sector. These decisions depend on the trade-off between the costs of entry and the benefits of accessing the formal credit market, itself a function of the quality of enforcement and property rights that allow for efficient loan recovery by lenders. Entrepreneurs save part of their profits for future consumption and these savings constitute the next period's supply of credit in the economy.In this context, the equilibrium interest rate that results from the interaction between the supply of lendable funds and the demand for credit is a key variable in determining the equilibrium level of formality. Indeed, lower entry costs and better contract enforcement unambiguously imply a larger formal sector, a higher demand for credit, and higher output as long as an infinitely elastic supply of funds is available at the prevailing interest rate (e.g., an open economy with no barriers to international capital flows and a competitive banking sector). However, absent these conditions, an increase in demand resulting from a higher rate of formality increases the interest rate, which weakens the links among reform, formality, and output.Finally, we present empirical evidence related to the implications of our model. We find that countries with lower entry costs or a higher quality of enforcement tend to have larger credit markets and smaller informal sectors and that this relationship is stronger when the banking sector is more competitive and the economy is more open to international capital flows. Using industry-level measures of financial dependence and control...

We investigate the effects of fee-shifting in an experimental litigation game. In our setup, a defendant may cause harm to a plaintiff. The defendant can take precautions to lower the probability of harm at a personal cost. In case of harm, the parties go to court, where the winner is determined by a rent-seeking contest. We compare two fee-shifting rules: under the American rule each party bears its own litigation costs; under the English rule the loser has to reimburse the winner’s expenses. We test the hypothesis that the English rule leads to higher litigation spending but also to higher care compared to the American rule. The experimental results largely support the predictions: fee-shifting leads to higher litigation spending, which motivates higher levels of care. When the parties are offered the possibility to settle their dispute out of court, fee-shifting leads to even higher litigation spending in court, but it neither affects the settlement rate nor care.

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We investigate the effect of leverage on bubbles in an asset market experiment. We expect higher leverage to produce larger bubbles because (i) it creates moral hazard in a setup with limited liability and (ii) it increases aggregate liquidity. Inconsistent with the moral hazard channel, which we test by holding aggregate liquidity constant, higher leverage does not produce larger bubbles. To understand this unexpected result, we run the same experiment with a different framing: instead of repaying debt, participants can earn a bonus. This bonus treatment produces larger bubbles, suggesting that more leveraged participants trade more cautiously to avoid default. Finally, bubbles are larger and increase over time when we keep leverage constant over time by injecting liquidity in the economy. Overall, these results suggest that higher leverage inflates bubbles not because of moral hazard but because of more abundant liquidity.