Forbearance Impedes Confidence Recovery (Revised)

This paper is a revised version of DP02-E-005, where the mathematical structure of the model in this paper is substantially different from the previous one. The finding that countries that take a slow approach to reform during a financial crisis run into problems of persistent stagnation is usually explained as follows: Forbearance policy (i.e., an implicit subsidy to inefficient sectors) distorts resource allocation, causing a supply shortage of resources to the productive sectors. I propose another explanation: Forbearance impedes the recovery of confidence that is lost during a financial crisis. If confidence is restored through Bayesian learning by economic agents based on observations of government actions, then the inaction of the government (forbearance) impedes Bayesian learning. The model shows that forbearance policy delays economic recovery. (forthcoming in Journal of Macroeconomics)