Government Loan, Guarantee, and Grant Programs: An Evaluation

R ecently, there has been a trend toward loan guarantee programs over other programs that support the credit market. From 1970 to 1998, the real value of outstanding federal loan guarantees rose at an accelerated pace, while the real value of direct loans, the other major government loan program, has remained about the same (see Figure 1). In particular, the Small Business Administration (SBA), which has provided government loan guarantees to small businesses since 1953, has experienced an unprecedented increase in its loan volume over the past three years. In December 1997, with the growing popularity of SBA loans, Congress passed an SBA funding bill that set aside $39.5 billion and $11 billion, respectively, for the SBA’s 7(a) and 504 business loan programs over the next three years. This more than tripled the current 7(a) level which was $10.3 billion in fiscal year 1997.1 The surge in loan guarantee programs prompts the question: Are loan guarantees the best way to provide benefits to targeted borrowers or to channel additional resources to targeted sectors? As the following paragraphs show, not in all cases. This article explains that conclusion by examining the economic consequences of three distinct methods of channeling resources to targeted borrowers: direct government lending, loan guarantees, and outright grants. While the logic applies to any credit market segment, the article particularly focuses on the small business sector. The analysis studies the changes in firm investment, bankruptcy cost, and business entry under each loan program in a