DP15180 Beyond Pangloss: Financial sector origins of inefficient economic booms

Author(s):	Frédéric Malherbe, Michael McMahon
Publication Date:	August 2020
Date Revised:	August 2020
Keyword(s):
JEL(s):	E22, G28
Programme Areas:	Financial Economics, Monetary Economics and Fluctuations
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=15180

Government guarantees to banks are ubiquitous. We study an equilibrium model where, in the presence of such guarantees, the equilibrium allocation can be characterised as Panglossian: it corresponds to that of a deterministic economy where the best possible state always occurs. However, GDP is inefficiently high and expected consumption inefficiently low. Financial sophistication magnifies this distortion, taking the allocation beyond the Panglossian outcome (i.e. with even higher GDP and even lower expected consumption). We argue that this mechanism is empirically relevant for advanced economies and suggest that the Great Recession, partly, reversed a Great Distortion.