On the Impossibility of Perfect Capital Markets

Perfect capital markets require linear budget constraints, without credit rationing creating any tight borrowing constraints before the end of agents’ economic lifetimes. Yet lifetime linear budget constraints are totally unenforceable. This paper considers what allocations can be enforced through monitoring in a simple two period economy when agents have private information regarding their endowments. Then default may not become apparent soon enough for any economic penalty to be an effective deterrent. Instead, borrowing constraints must be imposed to control fraud (moral hazard). Adverse selection often implies that some borrowing constraints must bind, creating inevitable capital market imperfections.