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Thursday, December 18, 2008

Avoiding "An Inefficient Credit Squeeze"

A proposal to get credit flowing again:

How to give banks confidence to lend to businesses, by Lucian Bebchuk and Itay Goldstein, Commentary, Financial Times: An important aspect of the economic crisis has been the drying up of credit... Why does credit fail to flow despite the infusion of so much additional capital into the financial sector? ...

In a modern economy, the prospects of businesses are likely to be inter­dependent, with each company’s success (and ability to repay) depending on whether other companies obtain financing. Companies commonly use components and services from other businesses and often sell their output to other companies or their employees.

Consider a bank choosing whether to lend to companies or park its capital in treasuries. Suppose that lending to any given company will generate an expected return of 10 per cent if other businesses obtain financing but an expected loss of 5 per cent if they do not. In such circumstances, the economy may get stuck in an inefficient credit freeze in which banks expect other banks to avoid lending and, given these expectations, rationally choose to hoard their capital to avoid the expected loss from lending when other banks do not.

Unfortunately, we cannot count on interest rate cuts and capital infusions into banks to get the economy out of such a credit freeze..., avoiding the 5 per cent expected loss will remain each bank’s rational choice as long as other banks are not lending.

Is there anything more the government could do? Yes, it can ... take on ... some of the credit risks involved in extending substantial new lending to businesses.

Suppose that the government wishes to get at least $200bn of additional lending to companies. Under one possible mechanism, the government would facilitate ... loans by agreeing to bear part of any losses ... in return for a share of the upside. In the example considered above, to induce banks to put together ... new loans it would be sufficient for the government to agree to bear any losses ... up to 10 per cent of the value of the extended loans.

The share of the upside received by the government could be determined through a competitive process. ... Under an alternative mechanism, the government would place $200bn in a number of funds. Each would be run by a private manager charged with putting together a portfolio of loans and compensated with a share of the profits generated by the fund. ...

When capital infusions and interest rate cuts do not work, the mechanisms we propose might provide effective tools for unfreezing credit markets.

The demand for loans is also a limiting factor, and I don't think making more loans available to businesses will be enough to jump-start the economy at this point. So more help for the economy than just making additional credit available will be required.

However, Ricardo Caballero says the problem isn't as hard to fix as most people believe:

Normality is just a few policy steps away: Economic agents of all sorts, from creditors to consumers, are frozen waiting for some sense of normality to be restored amid the financial crisis. However, normality is much closer —just a few bold policy steps away— than is the conventional wisdom. ...

I do not mean to say that this recession is an imaginary one. On the contrary, I believe it is a very serious recession. My point is simply that good policy has an opportunity to bring the recession back to familiar turf by defeating the extra gloom, and if this happens, the recession will become a manageable one from which current asset prices, on average, will look like once-in-a-lifetime deals. ...

Slow recoveries follow the typical credit crunch... But ... this ... is very different in nature. It is a systemic run on all forms of explicit and implicit insurance contracts, but with no shortage of resources on the side. If confidence recovers, the resources to support the recovery are abundant and ready. ...

    Posted by on Thursday, December 18, 2008 at 02:34 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (31)


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