Friday, October 03, 2008

Financial Fuss (1) - Market Queues

The latest financial fuss has brought out the usual range of confused economic thinking.

Commentators are suggesting that there is a shortage of credit. This is really an economic fallacy.

A shortage can only occur in a market, if the authorities get involved in price setting and keep the price too low. This happened frequently in Communist Russia. The government kept the price of bread low to assist the poor, but this produced frequent shortages and people would queue all day to get a loaf of bread, because the shops could be empty for days on end. If the price of any good is set too low, consumers demand more and producers produce less and shortages follow. When governments stay out of markets, prices rise and fall until the market clears and shortages and surpluses disappear.

This is what is happening in the financial markets. The Fed is keeping interest rates low, at a time when a new perception about financial risk has emerged.

Financial experts are saying that banks are unwilling to lend to each other. This is misleading. Banks are unwilling to lend to banks that might be bad credit risk. That is not a problem, but just good credit management.

The real problem is not a shortage of credit, but that investment banks with shonky assets on their books are unable to obtain credit at the cheap rates they paid in the past. They can still obtain credit, but they were unwilling to pay an interest rate that included sufficient risk premium to cover their likelihood of default. Some of the worst banks might have to pay “loan shark rates”, but that it what happens to those on the bottom of the heap. I presume that is why they are screaming about credit crunch. They really mean that they cannot obtain credit at the price they are willing to pay.

This full series is here.

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