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Thursday, July 8, 2010

Interview with Rob Hall...

A nice interview with Rob Hall.  Pertinent excerpt:
Region: Your recent paper on gaps, or “wedges,” between the cost of and returns to borrowing and lending in business credit markets and homeowner loan markets argues that such frictions are a major force in business cycles.
Would you elaborate on what you mean by that and tell us what the policy implications might be?
Hall: There’s a picture that would help tell the story. It’s completely compelling. This graph shows what’s happened during the crisis to the interest rates faced by private decision makers: households and businesses. There’s been no systematic decline in those interest rates, especially those that control home building, purchases of cars and other consumer durables, and business investment. So although government interest rates for claims like Treasury notes fell quite a bit during the crisis, the same is not true for private interest rates.

Between those rates is some kind of friction, and what this means is that even though the Fed has driven the interest rate that it controls to zero, it hasn’t had that much effect on reducing borrowing costs to individuals and businesses. The result is it hasn’t transmitted the stimulus to where stimulus is needed, namely, private spending.

The government sector—federal, state and local—has been completely unable to crank up its own purchases of goods; the federal government has stimulated [spending] slightly but not enough to offset the decline that’s occurred at state and local governments.

Region: Yes, I’d like to ask you about that later.

Hall: So to get spending stimulated you need to provide incentive for private decision makers to reverse the adverse effects that the crisis has had by delivering lower interest rates. So far, that’s just not happened. The only interest rate that has declined by a meaningful amount is the conventional mortgage rate. But if you look at BAA bonds or auto loans or just across the board—there are half a dozen rates in this picture—they just haven’t declined. So there hasn’t been a stimulus to spending.

The mechanism we describe in our textbooks about how expansionary policy can take over by lowering interest rates and cure the recession is just not operating, and that seems to be very central to the reason that the crisis has resulted in an extended period of slack.
Can Hall's financial frictions be explained by network effects?  I don't know I will think on it...I have in mind a model where agents are connected via some underlying network where the network topology would serve to exacerbate a contagion of negative beliefs regarding the probability that private lenders would be repayed.  This dynamic would be exacerbated further in the presence of some type of information asymmetry in which lenders were uncertain which agents would default.  In short by helping to spread contagion of beliefs, the network undermines trust (which is crucial in any lending/credit network).

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