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The Bonnie Tyler solution

Created:
8 October 2008
Written by:
Chris Dillow

The trouble in the money markets has set me thinking of Mancur Olson and Bonnie Tyler.

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The relevance of Mancur Olson is obvious to us economist types. It was he, in his classic The Logic of Collective Action, who best described the "free rider" problem. In many cases, individuals might want a good that can only be supplied collectively - a public good - and yet have insufficient incentive to contribute to that good. The upshot is that some valuable things don't get done.

And this is the problem we've had in money markets. A well-functioning interbank market is a valuable public good not just for the general economy, but for individual banks themselves; if each bank can borrow easily, it can lend profitably.

However, in the last few weeks, each individual bank has had insufficient incentive to contribute to this public good by lending itself. Each one has thought that its own individual interest lay in holding onto cash, even though it would also dearly like the market to be functioning well. Each bank has therefore wanted a free ride - it has wanted the public good of a functioning market, but not wanted to contribute to it. The result has been that the collective good has not been supplied, with consequences that consume half the Ten O'Clock news each night.

But what's the solution to this? Here's where Ms Tyler comes in. The Welsh songstress famously sang that "I need a hero." Which is just what interbank markets need.

If one bank boss were to say: "I'm not worried by the risk of default. I'm prepared to lend long to others" markets would unfreeze, because other banks would follow suit, being shamed into following the leader. We would, in game theory jargon, have a Schelling point that allowed us to shift from the non-co-operative Nash equilibrium to the co-operative one. Instead, we have a nervous stalemate; "where have all the good men gone, and where are all the gods?"

There's a precedent for this. During 1974, share prices slumped really horribly - now that was a real financial crisis. But in early 1975, the bosses of insurance companies acted heroically by agreeing to buy shares. The result was that the stock market soared that year.

Now, we don't live in an age of heroes. Bosses are gutless little bureaucrats and bean-counters who care for nothing but their own sorry skins. They're certainly not the "streetwise Hercules" Ms Tyler fantasised about. But the incentives to make the grand gesture have shifted. Today's cuts in Bank Rates have reduced the cost of borrowing overnight and hence the profits from borrowing short and lending long. And the Darling hedge fund - a government guarantee on bank debt - has reduced the risks of doing so.

The cost-benefit calculus, then, has moved in favour of the heroic solution. "Isn't there a white knight, upon a firey steed?"

MORE FROM CHRIS DILLOW...

Read more of my musings at www.investorschronicle.co.uk/chrisdillow.

A selection of my favourite blogs, and data sources, appears under 'External links' on the right-hand side of the page.

I moonlight in the blogosphere, too: http://stumblingandmumbling.typepad.com

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