Some Basic Finance Theory

4 December 2008 at 10:10 am 2 comments

| Peter Klein |

Sorry to sound like a broken record,* but journalists keep babbling about the “reduction in credit” as if it’s necessarily a bad thing. They don’t know any basic finance theory, which says that in well-functioning capital markets, positive NPV projects are funded and negative NPV projects aren’t. The talking heads think that the total number of projects funded, or the total amount of funding, independent of quality, measures the health of the financial system (and more is always better). They point out that consumers are finding it more difficult to get mortgages, that credit-card issuers are lowering borrowing limits, that firms are facing a higher cost of capital. (Of course, as we’ve pointed out before [1, 2], wild claims about credit markets being “frozen” are preposterous.) But changes in the allocation of credit are inefficient only if previous credit arrangements were somehow optimal. What if mortgages were too easy to get, credit-card limits too high, capital costs too low? A reduction in aggregate borrowing may be an improvement. Aggregate data aren’t helpful here.

For example, on the Diane Rehm show yeseterday two “experts” were talking about the proposed auto-industry bailout, when a wise caller raised this question: if the Big Three can return to profitability after receiving these government loans, then why wouldn’t private lenders be eager to make the loans? The pundits agreed that this was a good question but responded, matter-of-factly, that of course that can’t happen because credit markets have “completely shut down.” Rubbish!

* Readers under 30: ask your parents or grandparents what this expression means. It’s sort of like a corrupted mp3 file.

Entry filed under: - Klein -, Bailout / Financial Crisis.

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2 Comments Add your own

  • 1. Matt C.  |  4 December 2008 at 11:15 am

    A comment on the footnote. I would lower the age to 25. I remember being 5 and listening to the Bear’s Super Bowl Shuffle on a record. Then after that mostly everything moved over to Cassette tapes*.

    On to the important items. I can’t stand when news reports that “Credit is frozen” or the credit markets have “melted down”. They do very little questioning or even reporting whether or not this is true. They certainly don’t report the actual numbers, this is probably because the government isn’t spoon feeding them this information. What seems to be worse, Tyler Cowen there are economist who are feeding this notion.

    *For those of you under 10: ask your parents what a cassette tape is.

  • 2. David Hoopes  |  6 December 2008 at 11:19 pm

    Great post Peter!

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