Collectively, government investment and insurance operations dwarf those of the largest commercial banks. The size and scope of activities have grown over the last several decades to include the explicit and implicit guarantees of too-big-to-fail private and international financial institutions and non-financial firms, direct and guaranteed loans, and more traditional insurance and guarantee programmes such as for bank deposits.
She adds,
a universal mistake is that governments take their cost of capital to be their borrowing rate, irrespective of the risk of the investment under consideration.
Pointer from Mark Thoma.
Ever since the Basel Capital accords were adopted, the government in effect dictated that private bank loans must carry a risk premium over government bonds. Along with that, you have the mistake that Lucas identifies, which is the government evaluating its own loan guarantees and investment projects at a risk premium of zero.
Here is where this leads: if a private firm has to earn 8 percent interest to undertake a risky construction project, but the government can borrow at 2 percent to undertake that same project, then if that project is undertaken at all, it will be undertaken by the government rather than by the private sector. Thus, the system is rigged to put government in charge of where investment takes place.
We end up with something close to the worst of all worlds. Owners and managers of nominally private financial institutions earn outstanding returns. But we have capital allocation that closely approximates what would result from a socialist system.
Except that it seems to cost the government 100-300% more to do a job compared to a private entity — although that spread is decreasing.
…and the Fed is a big piece of this, not through open market ops (I agree with you that they’re not effective), but because it controls the cost of capital for private banks. Or, at least, the capital provided by depositors.
The central bank, omnipotent credit allocator, or impotent growth factor? Perhaps both as credit is more store than creator of wealth, immaterial in establishing growth, with interest rates only slightly shifting its profitability.
That may be true in a textbook world with exogenous money and banks as intermediaries that can easily be ignored. In the real world, though, Wicksell, Mises, Schumpeter, Minsky, the Bank of England, some at the BIS and many others have stressed that the textbooks are wrong and that credit that’s created by banks and retained on their balance sheets injects demand and growth directly into the economy, because it requires no prior savings.