Brad DeLong Gets Mathematical (Updated)

Any post that begins:

Suppose that a bank calculates that the net value of the mortgage to the bank as a fraction of its principal is equal to five years’ interest minus the chance of default:

Ï€ = 4r – d

is pretty likely to cause some readers’ eyes to glaze over or, at least, to lull them into a confused slumber. However, bear with Brad DeLong’s post on the logic of the plans to solve the credit crisis being put forward:

That is the logic behind Frank, Dodd-Obama, the Barr-Tyson plan being pushed by Hillary Rodham Clinton, and the other variants: that when the major cause of large-scale defaults is not the fecklessness of the borrowers but rather the fact that the market equilibrium has high interest rates that are themselves both the consequence and cause of high default rates, that the government has a market-making role to play by providing guarantees. This seems to me to be a good logic.

However, don’t gloss over this phrase:

And if there are a bunch of competitive banks, and if homeowners can comparison shop…

It seems to me that neither of those is a particularly good assumption. Taking the latter first, does the activity he’s advocating encourage comparison shopping? Should we subsidize those who aren’t inclined to comparison shop?

While it’s a lot easier than it used to be to comparison shop, as the banking industry consolidates, a process subsidized by the changes in banking regulations that have occurred over the years, it’s a lot less worthwhile. That’s the real hazard of governmental regulations that increase in number and complexity: an ever greater number may be required to offset the adverse effects of the previous crop of regulations. Note that I’m not suggesting that regulations per se are bad nor that they’re unwarranted, particularly in the present circumstances. I’m just suggesting that prudence is called for, a quality in short supply in the political sphere.

Update

Mark Thoma takes the adverse selection ball and runs with it, seeing Brad’s mathematics and raising him a graph or two.

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