Turner Turns (2) Debt Contracts

Adair Turner explains that banks create ongoing debt contracts.

Economists have argued that an all-equity economy would be more smoothly operating. However, human beings cannot deal with the resulting uncertainty. They want apparent certainty, especially in wage and debt contracts. They prefer fixed flows of revenue to partnership shares in business projects.

A debt contract is non-state contingent. Payments are not contingent on a future state of the world or on the success of a particular business project. This is good for capitalisation, because it overcomes the problem of costly state verification, the difficulty of working out both ex ante and ex post whether a business project is profitable or not. Asymmetric information makes lenders powerless compared to the borrower.