Crisis section

Crisis section
Gödel's Money : The future of freedom and civilization
Toxic Assets and the Disappearance of Inside Money (Part 1)

Senior Fellow, RIETI

Fifteenth Installment

Toxic Assets and the Disappearance of Inside Money (Part 1)

Bank runs and financial crises similar in nature

It has been suggested that the disappearance of money caused a deterioration of the real economy in the current financial crisis. Inside money (short-term credit between financial institutions) has unquestionably disappeared in financial markets. If it is accepted that this disappearance of money has caused a decline in the real economy, the problem lies in the reason for the disappearance of money.

The disappearance of inside money in the current financial crisis appears to be similar in nature to bank runs. As mentioned in the Tenth installment (October 19) of this series of articles, Professor Robert Lucas of the University of Chicago has also argued that the current financial crisis is a modern-day version of a bank run. Professor Gary Gorton (Yale University) and Professor Hyun Song Shin (Princeton University) are among the numerous economists who have expressed similar views.

Broadly speaking, there are two theories on the causes for "runs" such as "bank runs." One is that markets suffer chronic pessimism irrespective of market conditions, with panics occurring as a result of some form of mass psychology. Financial institutions spark runs en masse despite an absence of serious problems in the fundamentals, and inside money rapidly diminishes as a result. This is the classical model of bank runs (the Diamond-Dybvig model), a mechanism by which negative forecasts prove self-fulfilling. The Diamond-Dybvig model describes the bank runs that frequently occurred on a seasonal basis in the U.S. in the 19th and early 20th centuries and can be said to explain the mechanism underlying the bankruptcy of isolated local financial institutions in various locales.

Applying this theory to the complex modern-day financial system, however, presents somewhat of a problem. If this model is correct, then the amount of inside money should drop rapidly whenever market participants have negative "expectations" and rise sharply whenever their "expectations" turn positive. Financial crises would thus occur regardless of the economic fundamentals. This description seems a very unrealistic model of financial crises.

Another theory of bank runs is that depositors and creditors (other financial institutions) engage in a "run" because the real economy has worsened and bank assets deteriorated. According to this theory, financial crises occur because real factors (thought to be the anticipation of a worsening of the economy or the collapse of a bubble) degrade the asset portfolios of banks. Advocates of this theory go on to assert that economic crises are (perhaps) the optimal reaction to a downturn in the real economy. This theory was presented in 1998 by Professors Franklin Allen and Douglas Gale of the University of Pennsylvania and, in a world in which financial contracts are incomplete, there are instances in which bank runs enhance economic welfare as economic actions compensating for this incompleteness. Professor Allen et al have demonstrated with a simplified model that social welfare is higher after bank runs occurring during downturns in the real economy than in downturns without bank runs. They also developed the "optimal financial crisis" theory: bank runs do not by and of themselves cause economic losses and indeed are the optimal economic action for the sake of social welfare in the unfavourable environment surrounding a slump in the real economy. Admittedly, a theory that bank runs do not cause economic losses does seem counter-intuitive by nature.

Another interpretation of financial crises

Here I would like to present another approach to explain financial crises: the view that a collapse of asset markets due to the emergence of toxic assets leads to a disappearance of inside money. This I shall tentatively label the "toxic asset theory of financial crises." Many economists have noted since the start of the financial crisis last year that the emergence of toxic assets brought about a freezing of asset transactions and the collapse of asset markets. This hypothesis, this new contention, is that the emergence of toxic assets caused the recent disappearance of inside money (via the collapse of asset markets). If toxic assets are seen as causing inside money to disappear and production and employment to decline in the real economy, the crisis confronting the world economy since last year appears truly simple in nature. As will be discussed later, this hypothesis gives rise to extremely interesting policy analyses and policy recommendations.

First, we should confirm the first part of the theory, i.e., that the emergence of toxic assets caused the collapse of asset markets. This is the well-known phenomenon termed "the market for lemons" problem by Professor George Akerlof (University of California, Berkeley) in 1970 with respect to the used car market and called "counterparty risk" in the current crisis.

Akerlof focused on the asymmetry of information, with the buyer not having as much accurate information as the seller on the quality of a used car. The used car market has both good-quality used cars and clunkers (toxic assets), but buyers cannot distinguish between the good-quality used cars and the clunkers on the basis of appearance alone. Sellers, on the other hand, have detailed information on the quality of the used cars. When such an asymmetry of information exists, sellers are tempted to try to sell clunkers at high prices. Aware of this, buyers (expecting that sellers will try to get them to buy clunkers) will no longer offer high prices on the used car market and will only seek to purchase used cars at prices suited to clunkers. With market prices so low, sellers in turn will only wish to sell clunkers. The result is that transactions involving good-quality used cars disappear from the used car market and only clunkers are traded. Clunkers are also known colloquially as "lemons," and Akerlof termed the collapse of an asset market due to an asymmetry of information (and adverse selection) of "the market for lemons" problem.

The collapse of asset markets due to an asymmetry of information has been noted by many analysts in the current financial crisis. The counterparty risk of not knowing who (which financial institution) is carrying how many toxic assets and who will go bankrupt without repaying is essentially the same problem as the market for lemons in which one does not know which used cars are clunkers and which are of good quality.

(To be continued)

* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the November 23, 2009 issue of Kinzai Financial Weekly

July 7, 2010

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