Thinking Out Loud
Suppose I owned a small business, I was creditworthy, and I thought I had an investment opportunity that I could only take advantage of if I got a loan. Well, I look into it and I’m eligible for a loan. But the interest rate is pretty high. And yet, it’s not so high that the loan isn’t worth taking out. So I’ll take out the loan, right? Well, I might. But then again I might not if I thought that next week the government was going to take action that would make credit easier to get.
Similarly, suppose I owned a bank and was considering taking a risk lending some money. It looks a bit risky, but it also looks like a risk that will probably pay off. Do I make the loan? Well, I probably do. But what if I think that failing to take risks on lending money is likely to bring persuade the government to extend a helping hand?
18 Responses to “Thinking Out Loud”
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October 7th, 2008 at 4:22 pm
This way lies madness, Matt, or at least paralysis. If you start thinking about how people will react to you reacting about how they will react, well, you’ll never get anything done.
October 7th, 2008 at 4:24 pm
The first supposition only requires that the small business owner watches the news. That’s fine.
The second requires all banks to act in concert. You’re assuming that another bank won’t free ride. You and the other banks squeeze uncle sam, so I can safely lend to this small business guy with the good idea. In fact, because your squeezing Uncle Sam, I can jack up my rates on this guy.
October 7th, 2008 at 4:38 pm
1. Waiting for interest rates to come down: In theory, if markets are efficient and there are no “frictions”, then current lending rates will reflect expectations of a Fed move tomorrow. Individual borrowers are unlikely to be smart enough to time the market as a whole. In practice, will the bank lend me at a lower rate today if it expects that interest rates will go down tomorrow? For small lenders, probably no, for large one, maybe.
2. Banks vs. the gov’t. TWat the equilibrium will be depends, as Njorl points out, on whether there are many banks thinking alike. If it’s one bank vs the gov’t, then the question you’re asking has some legs, but not when every small bank has an incentive to make the loan and hope to free-ride when everybody else is bailed out.
October 7th, 2008 at 4:39 pm
Well, your expertise involves either borrowing money and paying it back with interest plus profit, or lending money and receiving the principal and interest.
I don’t think your expertise lies in discerning what the actions of the Bush administration will be.
It’s probably best to stick with what you know and go about your business. (Unless your real expertise is lobbying the government.)
October 7th, 2008 at 4:46 pm
Further: suppose you are looking to buy a house (even if you are a first time home buyer), you have AAA credit, and money available for the downpayment (all true of myself) — there’s no rush to do anything as prices are dropping precipitously. A lot of people with a lot more money than myself are sitting on their liquid assets right now, hoping to maximize that money. If you can wait it out, the incentives are strong to keep your cake and try to eat it to.
October 7th, 2008 at 4:50 pm
And what if you are a business, and you are thinking about making an investment, but the politicians are talking about making available tax credits… so if you wait, it might cost you less.
Now you understand why changing govt rules all the time is a bad thing.
October 7th, 2008 at 4:55 pm
Frank, if you’re so sure house prices are going to fall further, why don’t you short correlated assets, like stocks of construction companies? You’d make a ton of money.
October 7th, 2008 at 5:23 pm
Excellent point. Real option theory in action. What I do, in part, in my day job. Yes, it matters. And optimal policy is extremely sensitive to expected changes in risk.
October 7th, 2008 at 5:30 pm
Njorl (comment #2) is right. The two situations aren’t comparable, because what an individual small bank chooses to do has approximately zero effect on what the government will do, so there’s a “free rider” issue.
I’m surprised Matt missed this. I think it’s time for Matt to take some refresher econ courses.
October 7th, 2008 at 7:08 pm
Matt, welcome to our side. This is just another rendering of the leftist-populist conspiracy theory about the bailout: it’s the product of blackmail. This collective blackmail, a capital strike if you will, is not really coordinated and nefarious, but rather is the sum total of individual decisions precisely as you’ve described. The collective effect is precisely the same as a capital strike to force the government to implement a bailout.
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