Confusion as Commitment

Guillermo Ordonez and Jaromir Nosal

No 1026, 2012 Meeting Papers from Society for Economic Dynamics

Abstract: In this paper, we argue that government confusion about the nature of the shock to the economy when observing banks in distress has the potential to relax the time inconsistency of policymakers and the ensuing collective moral hazard that leads to endogenous systemic events. Government confusion lowers the expected benefit from intervention and may lead to a delay, for the purpose of learning more about the nature of the shock. This hinders strategic coordination and leads to what we call strategic restraint, as banks endogenously restrict the riskiness of their portfolio in relative to their peers in order to avoid being the worst performers. From the perspective of these novel forces, we analyze the optimality of government intervention and regulation.

Date: 2012
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