An important aspect of the economic crisis has been the drying up of credit that US banks normally extend to Main Street companies. Borrowing by businesses remains costly and difficult, with spreads between yields on corporate bonds and treasuries at extremely high levels.

Why does credit fail to flow despite the infusion of so much additional capital into the financial sector? The Treasury has been arguing that banks still lack confidence and we just need to give them time to adjust. The chair of the congressional oversight panel has suggested that banks’ reluctance to lend reflects their rational assessment of borrowers’ bleak prospects. But there is a third explanation: banks may not be lending because of their self-fulfilling expectations that other banks will not lend.