Does Adverse Selection Justify Government Intervention in Loan Markets?” Federal Reserve Bank of Richmond Economic Quarterly 80(1

G overnment involvement in loan markets in the United States is sub-stantial. For example, federal government direct and assisted lendingfor 1980 through 1987 amounted to $1208.1 billion, or 25.3 per-cent of total net lending in nonfinancial credit markets over the period (Gale 1991). Only $115.5 billion of this amount represents direct federal lending; the rest is accounted for by guaranteed loans ($251.3 billion), lending through government-sponsored enterprises ($441.8 billion), and lending subsidized by tax-exemptions ($399.5 billion). Can such interventions be justified as welfare-improving corrections of market failures? Some economists have argued that market failure is particularly likely in credit markets because of “adverse selection”—borrowers have unverifiable hidden knowledge about their likelihood of repayment.1 There is a type of externality in loan offers, and this can sharply constrain loan market outcomes. The author thanks Tom Humphrey, John Weinberg, Tony Kuprianov, and Tim Cook for helpful comments on earlier drafts. Some of the material in this article resulted from joint work with John Weinberg. The author is solely responsible for the contents of the article, and the views expressed do not necessarily reflect those of the Federal Reserve Bank of Richmond or the Federal Reserve System. 1 “The Federal government has played a central role in the allocation of credit among compet-ing uses. This paper illustrates that this sort of government program can under plausible conditions improve on the unfettered market allocation. A necessary condition for efficient government in-tervention is unobservable heterogeneity among would-be borrowers regarding the probability of default. The greater is such heterogeneity, the greater is the potential for default ” (Mankiw [1986]