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May 14, 2009
A cute story
It is August. In a small town on the South Coast of France, holiday season is in full swing, but it is the rainy season not much business is taking place. Everyone is heavily in debt. Luckily, a rich Russian tourist arrives in the foyer of the small local hotel. He asks for a room, puts a 100 Euro note on the reception counter, takes a key, and goes upstairs to inspect the room.A plan for economic recoveryThe hotel owner takes the banknote and rushes to his meat supplier, to whom he owes E100.
The butcher takes the money and races to his wholesale supplier to pay his debt.
The wholesaler rushes to the farmer to pay E100 for pigs he purchased some time ago.
The farmer triumphantly gives the E100 note to a local prostitute who gave him her services on credit.
The prostitute goes quickly to the hotel, as she owed the hotel for her hourly room use to entertain clients.
At that moment, the rich Russian comes back down to reception, informs the hotel owner that the proposed room is unsatisfactory, takes his E100 back, and departs.
There was no profit or income. But now no one has any debt and the residents of the small town look optimistically towards their future.
The paper "Liquidity Needs in Economies with Interconnected Financial Obligations" by Julio J. Rotemberg is essentially the story above expanded into a model of bank debts. It isn't a story about economic optimism. Instead it is a story about how relatively little outside liquidity injections can massively simplify a complex web of financial intermediation.
There is a problem with the story above as a lesson about economic optimism. Everyone has assets equal to their liabilities, so why would netting them to zero change their outlook about the future?
Posted by OneEyedMan at May 14, 2009 2:54 PM
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