Friday, 27 February 2009

Government insurance and a paradox of externalities

HBOS today announces losses of about 6% on its total corporate loan book, according to Robert Peston (ignore the 47% figure that he also gives - that is only generated by cherrypicking the scope of the statistic to get the most serious-looking number).

Can a bank charge a sufficient additional premium on its interest rates to cover this size of loss? It's unlikely. Small businesses regularly pay a spread of 6-10% over base (I've heard from some bank managers that they are charging up to 15% to some) but most loans are to much larger companies which have been able to get much better terms in the past.

So, if a bank can't charge enough money to cover its costs, should it stop providing the service? Strict microeconomic logic says yes: the service is not viable in the marketplace at the current price, so its price should go up and the volume of loans provided should be much lower.

But this is a classic example of market failure due to uncompensated externalities. Most discussions of externalities focus on negative externalities - for example the cost of pollution which is not paid by the polluter. This means that too much of a service is provided, because the cost to seller (and buyer) is artificially low.

As Tim Harford points out in one of his books (I forget whether it's Logic of Life or The Undercover Economist) positive externalities sound nice at first. For example, beekeepers make honey, which they sell for a market price - and the positive externality is that crops and flowers are pollinated for free by the bees. However, positive unpriced externalities cause an economic distortion just like negative ones; it may mean that too little of a service is provided, because the provider is not being compensated enough to encourage the amount that society wants. If people stop eating honey, beekeepers will go out of business, few bees will be kept and crops will not be pollinated. You can imagine the knock-on effects of that.

In this case, the positive externality is the economic activity generated by the loan, and the multiplier effect that grows the economy as a result. I don't know if there is an accepted model for this, but I would expect that £1 billion of corporate lending (which has a market price of say £30-50 million depending on the type of borrowers) would generate perhaps £300 million of extra annual activity including around £75 million of profits for the borrower and about £100 million of tax revenue. So the externality is substantial, because the overall benefit is far in excess of the price being paid to the lender, and also well in excess of the benefit to the borrower.

This is a strong argument for the government to subsidise corporate loans so that the economy can keep going. Even on a simple cost-benefit count, the government may make a profit because of the additional tax revenues generated. And society will benefit by much more.

Subsidies to corporate loans in non-recessionary times cause other distortions - as does fiscal stimulus of all kinds - and this argument becomes much less strong. Indeed, the subsidy is unlikely to be needed in those times, because losses on corporate loans are tiny compared to the figures for this year. But in times when there is a significant output gap - times when Keynesian stimulus is justified - a subsidy through partial guarantees of corporate loans is completely justified.

Indeed, the existence of externalities means that these guarantees are the only way the free market can operate properly, without distortions. That sounds paradoxical but the logic is sound.

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