By combining hidden types and hidden action, this paper shows that the exis
tence of credit rationing need not imply that lending exceeds the full-info
rmation level. In this plausible class of models, the appropriate policy is
not to subsidise or tax lending but to make alternatives to entrepreneursh
ip more attractive. Doing so may actually increase the number of those borr
owing to set up their own business and yield a strict Pareto improvement. T
he results extend to equilibria characterised by redlining. So, if interest
rates fail to clear credit markets, it does not follow that policy should
make loans easier to obtain. (C) 2000 Elsevier Science S.A. All rights rese
rved.