Indirect Finance and the Cousin Eddie Problem

with Xander Duykers (Economics Student, Samford University)

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Perhaps you’ve wondered what banks are for, exactly. Perhaps you’ve also heard it said that you shouldn’t lend money to family members and close friends. For a humorous example showing exactly why, look no further than the classic National Lampoon’s Vacation series.

The main character in the series is family man Clark Griswold, played by Chevy Chase. He works hard so that his family can have nice things. The “nice thing” in the series’ first installment is a vacation to Walley World. During their trip, Clark and the family take a brief detour to visit cousins Catherine and Eddie in Kansas. During this visit, Cousin Eddie reveals that he has been laid off and hits up Clark for a loan: “Could you, maybe, spare a little extra cash?” However, as Clark reaches for his wallet, asking “How much do you need?”, Eddie reveals that the “little extra” he needs is $52,000 for his mortgage.

The scene highlights the importance of financial intermediaries. Intermediaries like banks minimize the risk of borrowing and are essential for large-scale investment. These financial intermediaries operate through modes of indirect finance.

Lenders and borrowers benefit from indirect finance. Lenders are able to measure trustworthiness by looking at borrowers’ credit scores. Lenders also reduce other transaction costs in the market for loanable funds, and lower transaction costs means more lending. Borrowers benefit because they can get capital from a single lender in a single location.

Without the bridge that financial intermediaries provide, transaction costs associated with borrowing are too high, and the markets then encounter the Cousin Eddie Problem.

This problem is evident in the movie as Eddie is seeks to get loans directly. Because Clark is only able to spare about $500, Eddie will be forced to find the rest of the $52,000 he seeks elsewhere. Assembling that much in small loans is likely to be prohibitively costly. The scene also highlights one of the most important risks one incurs when lending to friends and family. Because of their personal relationship, Clark feels obligated to help Eddie even though Clark does not trust him and cannot repossess any of Eddie’s property if he defaults on the loan. Even if he had the power to do so, it’s difficult to enforce loan terms directly. It is especially easy to be forgiving and indulgent toward friends and family, which might not always be the best thing we can do for them.

Financial intermediaries and Indirect modes of financing solve the Cousin Eddie Problem by evaluating risk and trustworthiness and by creating an emotional buffer between borrowers and lenders. This increases overall trust in financial intermediation and makes more loanable funds available than there would be otherwise. Perhaps it’s something Clark should think about if he’s looking to finance his next trip to Walley World.

The post Indirect Finance and the Cousin Eddie Problem appeared first on Econlib.

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