Working Paper: CEPR ID: DP15180
Authors: Frdric Malherbe; Michael McMahon
Abstract: Government guarantees to banks are ubiquitous. We study an equilibrium model where, in the presence of such guarantees, the equilibrium allocation can be characterised as Panglossian: it corresponds to that of a deterministic economy where the best possible state always occurs. However, GDP is inefficiently high and expected consumption inefficiently low. Financial sophistication magnifies this distortion, taking the allocation beyond the Panglossian outcome (i.e. with even higher GDP and even lower expected consumption). We argue that this mechanism is empirically relevant for advanced economies and suggest that the Great Recession, partly, reversed a Great Distortion.
Keywords: N/A
JEL Codes: E22; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Government guarantees (H81) | Overinvestment by banks (O16) |
| Overinvestment by banks (O16) | Inefficiently high GDP (P24) |
| Overinvestment by banks (O16) | Inefficiently low expected consumption (D11) |
| Financial sophistication (G53) | Magnification of distortions (C59) |
| Government guarantees + Financial sophistication (H81) | Beyond panglossian state (P27) |
| Government guarantees (H81) | Distortions in GDP and expected welfare (D69) |
| Implicit subsidies from government guarantees (H81) | Lending at artificially low rates (G21) |
| Lending at artificially low rates (G21) | Excessive investment by firms (G31) |
| Government guarantees (H81) | Severe welfare losses (D69) |
| Capital regulation (G28) | Mitigation of distortions (H31) |