The Credit Surface and Monetary Policy (original) (raw)
2016, Progress and Confusion
I believe that credit plays a central role in the booms and busts of market economies, and even in milder fluctuations. But I do not believe that the credit conditions influencing booms and busts are driven primarily by fluctuations in riskless interest rates, or by the wrong riskless interest rates. When bankers say credit is tight, they do not simply mean that riskless interest rates are so high they are choking off demand for loans. They mean that many businesses and households that would like to borrow at the current riskless interest rates cannot get a loan. They are referring to the supply side of the credit market, not just the demand side. The reason some borrowers cannot get a loan at the same (riskless) interest rate that others do is that their lenders are afraid they may default. Risky interest rates (or spreads to riskless interest rates on loans that might default) are often more important indicators of economic conditions than riskless interest rates. Nevertheless, central bankers have paid scant attention to default in their macroeconomic models. 1 In my opinion, central banks should pay attention to, and influence, risky interest rates if they want to preserve financial stability. When lenders are afraid of default, they often ask for collateral to secure their loans. How much collateral they require is a crucial variable in the economy called the collateral rate or leverage. Lenders also worry about the creditworthiness of the borrowers, which in the case of firms is represented by credit ratings and in the case of households is often represented by a FICO credit score. 2 The credit conditions of the economy cannot be summarized accurately by a single riskless interest rate, but rather by an entire surface, where the offered interest rate from lenders can be thought of as a function of the collateral and the FICO score: r = f (collateral, FICO). 3 The higher the collateral, or the higher the
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