Posted by: Dirk | April 26, 2009

Liquidity and investment trap rediscovered by Edlin and Jaffe

Aaron Edlin and Dwight Jaffee in their article Show Me the Money in the Economists Voice are excellent. The authors show that banks have put billions of US-$ aside as excess reserves (Table 1 in their paper). 643.5 billions of US-$ in February 2009, to be precise. Investing this money would “would increase the M1 money supply and bank loans by as much as $4 trillion, because of what is known as the money multiplier. That would increase bank loans outstanding by more than 50% of their current amount.” The authors write on p.3:

In their more candid moments, bankers are saying that they would be delighted to lend more if only they could find more creditworthy borrowers. Of course, there is likely a distinction in this downturn between the private incentives to lend and the social benefits, which would include getting the economy moving again. After all, the reason why many business projects are not creditworthy is because the project’s prospective customers are cutting back since they too can’t get credit. Recession involve a coordination failure which tends to make the social return to loans higher than the private return.

This is a very good point. There is a private sector coordination problem. If somehow that money would be invested, all would be fine. This, by the way, is exactly the point of Keynes in his General Theory. He proposed that the money should be borrowed by the government and then invested. Have a look at my draft from last November for a more elaborate discussion of this topic. (Warning: this is a draft and it wasn’t good enough to get me invited to a job interview with a US university last winter.)

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