Economics and similar, for the sleep-deprived

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Update: seemingly not

Update: Oh yeah!

Monday, October 03, 2011

Always pushing up the wrong channel

Look, I want to believe in the credit channel, always have done (ever since I worked in macroprudential surveillance, as its existence would have made my division institutionally more important at the Bank of England than it actually was). But it doesn't, it really doesn't.

It really looks plausible that there might be an exogenous channel by which bank lending could contribute to investment demand. You can tell all sorts of sensible-sounding theoretical stories, which presumably account for the extraordinary tenacity of Bernanke & Blinder (1988). Basically, they are all variations of some sort or another on the generic Fatty-and-JimBob model set out below:

Generic Fatty/Jim-Bob Credit Channel Model

Fatty is a bank; he has capital, he borrows money in the deposit market or some other how, and he makes loans to the various community of Jim-Bobs, who all run small businesses. The Jim-Bobs form a continuous distribution over the rates of return of their projects - if they can cover their financing costs, then they will apply for a loan from Fatty. For some reason or other, Fatty does not lend money to all the Jim-Bobs who want loans (and whose rates of return exceed the social cost of capital). Possible reasons:

1) Fatty only has limited regulatory capital, and so he has to ration lending more or less at random
2) Fatty's cost of funds has a risk premium built into it, so he can't lend to Jim-Bobs who don't earn more than his own cost of funds (which is higher than the social optimum)
3) Various blah about asymmetric information.

All of these models end up with some version of - make Fatty's business more profitable, reduce his cost of funds, buy some of his Jim-Bob loans off him to free up capital, guarantee some of the JB loans, and Fatty will make more loans to more Jim-Bobs - which will have a similar effect on investment spending as would government spending. But so much cheaper! And largely off budget! And politically acceptable!

The trouble is, it doesn't work that way. Basically the problem is our old friend nonergodicity. Not only do Jim-Bobs not form a well-behaved and known distribution of their rates of return, they don't form a distribution at all. They're all individual speculative, uninsurable risks and the decision to lend to them or not is not taken at the margin (old London Business School proverb, taught in the context of estimating the correct cost of capital for use in the Net Present Value Rule - "If changing your cost of capital by one per cent makes a difference between positive and negative NV, rest assured - it's negative".

Basically, the near-equilibrium situation in which a movement in Fatty's cost of capital, or funding, or even some insurance against the assymetric information risks he faces makes a difference by shifting some marginal projects from positive to negative NPV, is never the one that pertains. Institutionally, banks are more like a light switch than a tap - they're either in full risk-on mode (in which case they will lend to any project that looks kindasorta OK, and deal with the funding and capital consequences later), or in risk-off, batten-hatches mode (in which case they will do anything to avoid putting more capital at risk, because any incentive, be it carrot or stick, that you might want to set out to "get the banks lending again", is less of a factor than the danger of losing the money".

The point here is that Keynes The Master did not fuck up by not including a separate banking industry in his model; the investment decisions and motivations of the bankers in deciding whether or not to provide finance to the rest of the economy are exactly the same as those of industrial capitalists and are equally adequately described by Chapter 15. Bankers make their decisions based on whether loans will succeed or fail, which depends on their assessment of demand in the economy, and the model closes. Small-ticket subsidies and buggering about with guarantee schemes, and securitisations and blah don't work, unless they are big enough to constitute a fiscal policy in and of themselves. And I think that we can all see why, if carrying out fiscal policy is your aim, then doing so via those institutions which are the British banking system is unlikely to be the most efficient way in which to do so.

To an extent, this is me and the Old Keynesians versus Bernanke, Brad and the New Keynesians. A liquidity trap doesn't come about because of an increase in risk aversion or a shift in the demand for risk-free assets or anything like that - for some purposes it's useful to model it that way, but that isn't how it happens. Any model which has a smooth function at its heart isn't really Keynesian, including most of those in the General Theory in chapters other than 15. People don't just suddenly wake up feeling a bit more nervy and highly strung - their "risk aversion" increases because they are worried more about some specific bad thing about to happen to things they were previously thinking about investing in.

Which is why the latest proposal from the coalition to revive the good old small business loan guarantee scheme (with added bells, balls and whistles to make it look more like a CDO or like Fannie Mae, help us all) are going nowhere. These things only ever work at all, even in the dull-but-worthy, largely-economically-irrelevant sense as a form of industrial and/or regional policy, and the fact that they basically represent industrial policy gives you a clue that they're going to be done in way too small size. If we happen to get out of this crisis, it won't be because of that.
2 comments this item posted by the management 10/03/2011 01:37:00 PM

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