Saturday, October 11, 2008

Institutions are Over-Rated

Economic institutions are not the same as economic functions. "Saving" and "investment" are economic functions. A bank is an economic institution that provides an economic function (bringing savers and investors together). But the function can occur without a particular institution, because alternative institutions can take its place.

The retained earnings of corporations are an example of an institution that could substitute for a bank in bringing saving and investors together. When banks were operating well, corporation ABC earning profits would often pay out some of those profits to its shareholders as a dividend. The shareholders would deposit those dividends in a bank, who would lend them out to corporation XYZ, who would undertake an investment project. Would the economic function be fundamentally different if corporation ABC reduced its dividend and loaned the funds to corporation XYZ directly? Or merged with corporation XYZ? Or invested internally?

You might observe that banks have close substitutes from competing institutions in some areas, but not others. You might say, for example, that banks are the only institution lending money for home purchases. But even if your observation were not exaggerated (employers often make home loans to employees), it comes from a time period when banks were functioning well. The real question is whether alternative institutions would bring funds to home purchases EVEN IN THE ABSENCE OF WELL-FUNCTIONING BANKS. I think they would. That's not to say that the world would be completely the same without banks. But the basic economic functions would still happen.

Democracy is another institution with an impact that has been good (I kinda like this free speech thing), but highly exaggerated. Operating the monopoly on force, and mediating between competing groups served by that monopoly, is a very important function. But a political institution such as election is only one way to serve that function. The possibility of ready institutional substitution for democratic political institutions is why democracies and autocracies have similar public policies in so many areas. It is critical that the basic economic function be performed, but there are multiple institutions that can perform it.


Tino said...


Not only that, we should probably observe that the demand for loans and credit will go down in general. American Households have just witnessed a shock to their future wealth. They are poorer than they thought (at least by 5 trillion in housing and 7 trillion in public equity, and probably by similar figures in labor earning, private equity etc). So they should adjust their books by reducing debt and increasing personal savings.

We are already observing this in the sharply falling trade deficit. I would predict a current account surplus within a couple of years. The government is again increasing it’s borrowing after a few years of reduced deficits, yet another reason for increased net savings, and a decreased demand for loans.
The self-employed are another group that even in normal times are constrained in decoupling saving and investment decisions. About half of all corporate equity is private.

While I find Professor Mulligan’s comments generally convincing, there are a few issues that he seems to downplay. If everyone is trying to adjust their balance sheets in the same direction all at the same time, there is a risk of Fisher style debt-asset deflation cycle. It may well be that state intervention can be justified, even given the huge costs (which I do not dispute).
Also, of course the economy could function without perfectly with a reduced financial sector. But how about the adjustment cost? But up until a few months ago a lot of firms and households were counting on short term credit. Isn’t the problem the drastic cutoff, more than anything else? How long would it take for new firms to enter the market? Even if it only takes 2 years, couldn’t that lead to a deep recession, if the economy has to rebuild an important function?

Lastly, it seems one would understand this crisis better if we took Knightian uncertainty into account. If markets are falling more than is justified by a reduction revenue streams, its because of the enormous uncertainty around. Investors are not confident in how to calculate risk anymore, they don’t know what the correct valuation models are anymore. Compared to a month ago the number of potential factors that could go into the valuation of any single asset have gone up dramatically.

UofC Uncommon Economics said...

Do you think that corporations can fulfill the role of banks more efficiently than banks themselves? And if so, do we need banks in our economy?

Unknown said...

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