The liberalization of the household credit market is commonly regarded as a beneficial policy because it enlarges consumers' opportunity sets. This view neglects the fact that increasing household debt can lower national saving, investment and growth, and thereby reduce the standard of living of current and future generations. This point is relevant for policy-makers currently confronted by the worldwide shortage of saving due to high government deficits, growing demand for capital from the dynamic economies of Asia, Latin America and Eastern Europe, and falling private saving in OECD countries.

In Discussion Paper No. 1108, Research Fellows Tullio Jappelli and Marco Pagano analyse the welfare implications of liquidity constraints for households in an overlapping generations model with growth. In a closed economy with exogenous technical progress, liquidity constraints reduce welfare if the economy is dynamically inefficient. But if it is dynamically efficient, some degree of financial repression is optimal in the steady state, even though it hurts some generations in the transition. In an open economy with capital mobility, financial repression of domestic households is never optimal at the national level; but generalized capital mobility leads to an inefficiently low steady-state supply of saving at the world level. If each country liberalizes the internal credit market, world saving and investment fall in the wake of a generalized move towards free capital movement. With endogenous technical progress, financial repression at the world level may increase welfare even along the transition path, thus leading to a Pareto improvement. Thus, it is argued that a worldwide move towards capital mobility can lead to an inefficiently low steady-state capital stock and that this inefficiency can be avoided only by international policy coordination.

The Welfare Effects of Liquidity Constraints
Tullio Jappelli and Marco Pagano

Discussion Paper No. 1108, January 1995 (FE/IM)