Economics for Card

Monday, 3 August 2009

Supply and demand: bank loans

Scott Sumner has published a couple of good articles about the difficulty of understanding supply and demand, and Robert Peston's posting today may be an excellent illustration of that.

Robert says:

Here's the great and resonant unknown of the moment.

Is the credit contraction a reflection of less demand from you, me and millions of others? Or are the banks rationing much more than they had been doing?

The answer is - probably - a bit of both.

But does that make any sense? Well, it could - but is it plausible that demand for loans just happens to fall at the same time as the banks tighten their standards? And why would the banks "ration" credit anyway? Professor Sumner might give a simpler explanation.

Occam's razor, as you know, says that the simplest explanation is usually the best. So can we identify a single cause of this phenomenon? Yes we can.

Imagine that there is a stable market for credit in 2007. Then just one thing happens: the supply curve for loans shifts leftwards. This means that a lower amount of loans will be supplied at any given interest rate. Assume that the demand curve stays exactly the same.

The consequence? Loans get more expensive; fewer transactions take place. A new equilibrium is reached, further leftwards along the same demand curve, where a lower quantity of transactions takes place at higher prices.

People might be demanding just as much credit - indeed, they could be looking for more. Some businesses need more working capital and some people want to borrow to replace temporary lost income from unemployment or wage cuts. But if the supply has fallen, then the price of borrowing will go up and the amount will decline.

Why would supply fall? Two reasons. First, if wholesale lending is no longer available. Second, if loans have become riskier - and therefore their cost has gone up. Both of these effects shift the supply curve upwards.

Anecdotally, this...