Sixteenth Installment
Toxic Assets and the Disappearance of Inside Money (Part 2)
Asymmetry of information generates a market for lemons
The "counterparty risk" that has drawn such attention during this financial crisis stems from the fact that global financial markets have become what Akerlof termed a "market for lemons." According to Professor John Taylor (Stanford University), counterparty risk was already widespread and deepening in the financial markets in 2007 (Getting Off Track). Counterparty risk - the risk that a bank borrowing short-term funds in the interbank market might go bankrupt, making the loan uncollectible - corresponds precisely to the risk in the lemon market of buying a used car and perhaps ending up with a clunker (lemon). In both instances, the problem arises from the asymmetry of information between buyer and seller that puts the buyer in a position of remarkably high uncertainty. This uncertainty stems from the co-existence in the market of both good-quality assets (good-quality used cars) and toxic assets (clunkers) that are indistinguishable by market participants other than the owners.
The market for lemons problem is thus a common problem that can occur in any asset market. Although its impact is limited when the problem occurs in the used car market, why do production and employment throughout the economy experience a "once-in-a-century" contraction when financial markets turn into lemon markets? The disappearance of wealth accumulated thereto due to a crash in asset prices has a huge negative wealth effect, but this alone is not a sufficient answer. Another reason worthy of examination is that the assets no longer being traded due to the market for lemons problem have apparently been functioning as inside money. Because inside money disappeared as the emergence of toxic assets created a lemon market problem, the economy as a whole ran short of money (short of liquidity) and the real economy fell into disorder.
Bad money chases out good money
To aid our understanding, let us consider a specific example. Let us imagine an economy in which residential mortgage-backed securities (RMBS) have come to serve as money. When consumers purchase consumer goods in this economy, they can pay not only in cash but also in RMBS (in other words, sellers will happily accept RMBS in place of cash). Cash thus functions as external money and RMBS as inside money in this economy. Defining our terms once again for the sake of clarity, external money is money whose supply is determined outside the economic system. Paper currency and coins whose supply is determined by the government are examples of external money. Inside money is an asset issued by a private-sector entity that performs the role of money (i.e., a medium of exchange). RMBS are bonds issued by private-sector financial institutions, and were not designed institutionally to serve as money (a medium of exchange for consumer goods transactions). Nevertheless, the sellers of consumer goods may be willing to accept RMBS in place of cash as a means of payment (as would be the case when sellers believe that, when they become buyers in subsequent purchases, payment by RMBS would not be rejected by these other sellers). In other words, if the circulation theory of money holds for RMBS, then RMBS become "de facto" money.
Let us also say that the supply of cash in this economy is excessively small vis-a-vis the total supply of consumer goods, while the supply of RMBS is plentiful and in excess of the total supply of consumer goods (to simplify matters, changes in prices will not be considered and the prices of both consumer goods and RMBS will be presumed to be 1). Consumers cannot purchase all of the consumer goods supplied just with the cash they have on hand, but they can do so if the inside money RMBS are used as a means of payment.
If the circumstances are such that RMBS circulate as inside money, then the total supply of consumer goods in this economy will be purchased by consumers, and aggregate supply will equal aggregate demand. There will be no gap between supply and demand, and the economy will be in a state of full employment.
Let us then say that a housing bubble occurs and that "toxic assets" slip into the RMBS market due to the sudden bursting of this bubble; toxic RMBS (bonds that will certainly be defaulted on) appear in a market in which there had only been good-quality RMBS (no-default bonds) prior to the bubble. The holders of these toxic RMBS will be aware that these bonds are bad, but market participants other than these holders will be unable to discern which RMBS are toxic bonds (i.e., there will be an asymmetry of information). This is considered an extremely realistic portrayal of the market at the time of the 2008 financial crisis. This asymmetry of information transforms the RMBS market into Akerlof's market for lemons. Via exactly the same mechanism as that in a used car market that has become a lemon market, the good-quality RMBS will no longer be traded and only toxic RMBS will be available. Bad money will chase out good money, and the transaction price of RMBS will converge toward zero.
As a result of this, consumers will have no choice but to rely solely on cash as a means of payment when purchasing consumer goods (they cannot use RMBS as a means of payment because sellers will refuse to exchange consumer goods for RMBS priced at zero). Let us say that, despite increasing the supply of cash (the supply of liquidity) by an enormous amount, the central bank is unable to supply enough cash to cover all of the economic transactions in the private sector (this is also likely a realistic presumption). In this scenario, the amount of goods that can be purchased by cash will be far lower than the total supply of consumer goods and, with aggregate demand lower than aggregate supply, a recession will ensue. Consumption, production and employment will fall. Calculating with a number of mathematical formulas, it can be determined that the labor wedge will also worsen when inside money has disappeared.
In this example, the emergence of toxic assets caused inside money to disappear, resulting in a shortfall in the money supply. This scarcity of money produces circumstances in which aggregate demand falls below aggregate supply. When the mechanism of the financial crisis is understood in this way, the policy response required becomes self-apparent.
(To be continued)
* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the November 30, 2009 issue of Kinzai Financial Weekly
