Credit Rationing: Reply

John Riley has made "A Further Remark" on Section IV, "Observationally Distinguishable Borrowers," of our 1981 paper in this Review. In that paper, we defined two types of rationing. Criterion a rationing occurs when, among observationally identical borrowers, some get loans and others do not, and the rationed borrowers cannot get credit at any interest rate. A second type of rationing (criterion b rationing) occurs when entire types cannot get credit at any interest rate, although they would get credit if the supply of funds were sufficiently large. This type of rationing is often termed "redlining. " We showed that, given the special simplifying assumptions of our model and disregarding the incentive effects of loan contracts, if there are many types of observationally distinguishable borrowers, only one type is subject to criterion a rationing. Riley goes on to conclude that rationing becomes of insignificant importance as the number of observationally distinct groups becomes large. More specifically, the conclusion that one might be tempted to draw from Section IV of the 1981 paper is that "Given the special simplifying assumptions of the paper, and ignoring the incentive effects of interest rates delineated in the paper, as the number of observationally distinct groups increases, the proportion of the population subject to criterion a rationing decreases, while the proportion subject to criterion b rationing decreases or increases depending on how the population is partitioned. " We did not include this conclusion (or even a less verbose version) in that paper, because we feared it might mislead readers in either of two ways. First, the reader might not have been aware that the conclusion is very sensitive to the special assumptions of the adverse-selection sections of our 1981 paper. By the time we published our 1981 paper, our research extending that model, for example, to multiperiod settings and to situations where collateral and interest rates were both employed, had made it amply clear that the conclusion that type a rationing disappeared in importance as the number of types in the economy increased was not, in fact, generally valid. ' Second, even within the special context of those special simplifying assumptions, the conclusions would mislead a reader who was not aware that criterion b rationing (redlining) has consequences for allocative efficiency and macroeconomic policy that are as important as the consequences of criterion a rationing. We are not so presumptuous as to believe that the assumptions we made in our 1981 paper should be interpreted as a literal description of the economy. Those assumptions were made to provide the simplest model in which the market equilibrium would be characterized by credit rationing. If one is interested (as we are) in understanding the importance of rationing in the economy, as opposed to its importance within a specific model, one should investigate the nature of rationing in more general models that are formulated to more closely resemble the actual economy. This we have done in a series of papers, which show that with many observationally distinguishable groups there may be rationing of several, or even of all groups. For