Seventeenth Installment
Toxic Assets and the Disappearance of Inside Money (Part 3)
The true nature of external diseconomies
Summarizing the discussion through the previous articles, the mechanism of the financial crisis can be recapped as follows: (1) toxic assets emerged in great number due to the collapse of the housing bubble, (2) the asymmetry of information in the financial assets market consequently rose, and adverse selection (sometimes referred to as the lemon problem) became increasingly serious, (3) the resultant malfunctioning of the financial markets caused inside money to disappear (or hindered the circulation of cash), and (4) consumption, investment and employment swiftly declined in the real economy. Looking at the matter in this fashion, one would expect a policy response that would seek to eliminate the fundamental cause of the disappearance of inside money (i.e., the presence of toxic assets).
Before discussing policies, though, we should first determine if this is a valid understanding of the financial crisis. I would like to begin with some explanatory notes. My standpoint - the assertion that the presence of toxic assets caused an asymmetry of information and triggered the recession (declines in consumption and employment) combined with the existing theoretical analyses of the current economic crisis by economists in the U.S. and Europe - is not necessarily the standard one. Generally speaking, the contention that both toxic assets and the recession were the products of the housing bubble collapse is perhaps the prevailing view; conventional wisdom also holds that the recession itself generated toxic assets. Granting the validity of these positions, I want to direct attention to a point that has been overlooked thus far: there also exists a cause-effect relationship between toxic assets and recession that derives from serious external diseconomy effects. That toxic assets help bring on recessions appears to have been demonstrated to a certain degree by Japan's disposition of bad debts and its economic recovery (see the debate between the author and Professor Krugman in No. 4 (August 24) and No. 5 (August 31) in this series of articles). In the current financial crisis as well, the problem of adverse selection of inside money is an extremely important mechanism by which the collapse of the housing bubble led to a recession, i.e., a decline in aggregate demand. Fundamental resolution of the recession is unlikely unless this issue can be addressed directly.
The disappearance of inside money due to the existence of toxic assets could be extremely protracted. This is not simply an inference drawn from the historical facts of the "lost decade" of the 1990s in Japan and the Great Depression in the U.S. (which naturally continued for more than a decade). The essence of the problem lies in the fact that the disappearance of inside money due to adverse selection is an external diseconomy effect for corporations, banks, and households. Because the disappearance of money is similar to the appearance of pollution as an external diseconomy effect, banks, companies and other private entities do not have the incentive to try to resolve this problem at their own cost. Consequently, the disposition of toxic assets would be perpetually postponed and the external diseconomy effect of the disappearance of inside money would continue indefinitely if holding toxic assets did not carry any costs for financial institutions (exactly as would occur if the problem of pollution were not addressed). Retaining toxic assets and bad debts increases the costs for creditors, of course, so in reality the toxic assets will eventually be cleared off the books. However, the timing of this disposition does not take into consideration the externality of the disappearance of money and so disposition will come about much later than would be optimal for the economy as a whole. Resolution of external diseconomies in the private sector is thus difficult, and some form of policy involvement is necessary (as regulations and policies were deemed necessary for the pollution problem).
The reasons a policy response is needed
Thinking in this way about the essence of the financial crisis enables one to reassess the relationship between macroeconomic policies (fiscal stimulus and monetary easing) and policies for the disposal of toxic assets from a new perspective. In the face of shrinking aggregate demand due to some shock from outside, a Keynesian economic framework would call for a macroeconomic policy of stimulating demand through supportive measures and provide a "painkiller" to assist the economy in making a self-sustained recovery. Macroeconomic policies are not designed to identify the "fundamental causes" for shortages in demand nor are they expected to directly resolve these. Because responsibility for deficient demand lies with a complex web of factors, the causes underlying a lack of demand cannot be understood immediately nor can economic policies be devised to directly eliminate those causes. Therefore Keynesian economic thinking holds that the only step that can be taken is stimulating demand through stopgap fiscal stimulus and monetary easing. The tacit premises here are that short demand is a temporary phenomenon and that the economy will recover in a self-sustained manner.
If a shortage of demand in a financial crisis is determined to be caused by the disappearance of money due to adverse selection as toxic assets emerge, then adopting policies that directly target the cause (the existence of toxic assets) would be the most efficient use of policy resources. Stopgap Keynesian policies alone will never resolve the problems of prolonged external diseconomy effects.
Policies to dispose of toxic assets and sweep them from the market will eliminate the asymmetry of information and solve the problem of adverse selection. Specifically, policies are needed that allow government agencies such as the Industrial Revitalization Corporation of Japan to buy up toxic assets or inject public funds into financial institutions and thereby strongly encourage these institutions to amortize their toxic assets. Because the lemon problem (counterparty risk) of not knowing where toxic assets lie hidden causes inside money to disappear and harms the economy, requiring banks and other institutions to disclose information on which of their assets are toxic and making that information public would resolve the problem. In other words, the policy objective should be to curb the problem of adverse selection by alleviating the uncertainty about which residential mortgage-backed securities are toxic, which bank loans are nonperforming, and which companies have off-the-book liabilities. Policies enabling the government to buy up toxic assets or inject capital into banks will be needed to that end.
Viewed from this standpoint, the disposition of bad debts that troubled Japan for many long years can be regarded as having performed the extremely significant public task of eliminating external diseconomies.
(To be continued)
* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the the December 7, 2009 issue of Kinzai Financial Weekly
