Privatizing profits and socializing losses with smoothly operating capital markets

We design a three periods two overlapping generations model to challenge some of the prevailing views regarding privatizing profits and socializing losses in an environment characterized by smoothly operating capital markets. The model has a secondary asset market impaired by adverse selection and moral hazard. An exogenous stochastic shock renders some assets toxic. In the basic setup a tax financed scheme which removes toxic assets exacerbates the moral hazard problem and worsens the resource misallocation. However, introducing a “search for yield” with dynamic spillover effects and/or considering a labor market with some friction makes intervention welfare improving.