Eighteenth Installment
Toxic Assets and the Disappearance of Inside Money (Part 4)
Encouraging the disposal of non-performing loans also counts as monetary policy
Policy measures for controlling the quantity of money have thus far been thought limited to the manipulation of interest rates or of the supply of base money (monetary policy) by the central bank. As has been argued in this series of articles, however, if assets with high liquidity (mortgage-backed securities, stocks, real estate) are also considered inside money in the broad sense, then policies that reduce the asymmetry of information in asset markets can also be regarded as policies for controlling the supply of inside money. Adverse selection (the lemon problem) will reduce the quantity of inside money in asset markets. In other words, if the lemon problem in asset markets escalates, these assets will lose liquidity and consequently will no longer be able to function as money (a medium of exchange for goods and services). Triggering this lemon problem would be an increase in these toxic assets in asset markets and greater uncertainty stemming from an inability to determine which assets are toxic assets. Hence, policies that promote the disposal of toxic assets (or the disposal of non-performing loans at financial institutions) can serve as policies for controlling the quantity of money in a broad sense.
During the prolonged economic slowdown that began in the 1990s, the need to dispose of non-performing loans has been regarded as an empirical rule in Japan, but the disposal of non-performing loans as a public policy of clear-cut significance rested on a fragile theoretical base (myself and others have argued that non-performing loans lower productivity, but this has not necessarily become a generally accepted argument). As toxic assets are related to the quantity of inside money, policies pertaining to the disposal of toxic assets may be seen as policies pertaining to money supply. Toxic asset disposal thus becomes a natural extension of ordinary monetary policy.
Policies for toxic asset disposal differ, however, from ordinary macroeconomic policies such as raising and lowering the policy interest rate.
Given the need to distinguish between toxic assets and prime assets in publicly-disclosed information, there is a call for policies that promote liquidation and rehabilitation for individual borrowers (companies and households). Just as company rehabilitation was carried out in Japan through the creation of the Industrial Revitalization Corporation of Japan to buy up non-performing loans, so a government-related institution (Asset Management Company, or AMC) to handle exclusively the purchasing and restructuring of toxic assets should be established for a limited timeframe and put into action. Research at the IMF and elsewhere has pointed to the need for an AMC as a lesson to be drawn from past financial crises.
It is also imperative that financial institutions be incentivized to dispose of toxic assets. To that end, U.S. markets may find it necessary to conduct annual or biannual asset valuations (stress tests) for the next several years. There is also a need to ensure that banks and other financial institutions adopt strict and highly transparent accounting standards. Moreover, in order to prevent the re-emergence of anxiety in U.S. markets while rigorously disposing of toxic assets, the U.S. government should perhaps set aside a certain amount of public funds in preparation for injecting capital into financial institutions.
The toxic assets involved in the recent financial crisis were dispersed globally. Efficient disposal of these will require international policy coordination on the handling of toxic assets. For example, consideration might be given to internationally harmonizing corporate and personal bankruptcy procedures and to establishing an international organization to buy up toxic assets (the ECB could be said to be fulfilling a de facto role as an organization for buying up international toxic assets in Europe).
As argued above, policies for promoting toxic asset disposal will center on institutional policy measures implemented by a government organ rather than by a central bank. In light of the relationship between toxic assets and inside money, however, central banks could come under pressure to change their monetary policy rules.
New policy rules for controlling money
Depending on the market environment, certain types of assets (e.g., RMBS and real estate itself) function as inside money in times of financial crisis as well as in the ordinary business cycle. If assets functioning as inside money become increasingly toxic, the asymmetry of information will grow and the lemon problem will emerge, with these assets thereafter losing their function as inside money. Conversely, reducing the toxic assets in a certain asset class lessens the asymmetry of information and allows this class of assets to newly function as inside money. Increases or decreases in toxic assets even during the ordinary business cycle are thought to be closely related to increases or decreases in inside money, i.e., to increases or decreases in the quantity of money in the broad sense. Based on this hypothesis, an (unexpected) increase or decrease in toxic assets will be construed as an (unexpected) increase or decrease in money, which itself will be interpreted as a "monetary shock" that sets off cyclical changes. In an economy featuring price rigidity, monetary policies that dampen such monetary shocks improve the welfare of the economy as a whole. It could be concluded, therefore, that monetary policies carried out by the central bank should respond to increases or decreases in toxic assets. As a rise in non-performing loans produces a drop in the quantity of inside money, so the central bank should increase the money supply (i.e., lower the policy interest rate).
One approach might be to employ a rule of adjusting the policy interest rate in line with the percentage of toxic bank assets (defined as the ratio of toxic assets to total assets or the ratio of non-performing loans to total loans) in combination with the ordinary Taylor rule as monetary policy rules. Even better might be to include securities companies and other financial institutions broadly connected with the settlement system alongside banks in determining this toxic asset ratio, the outcome being the following policy rule:
Policy interest rate = neutral nominal interest rate + α (real inflation rate - inflation target) + β (GDP gap) - γ (toxic asset percentage)
Verification through exacting theoretical models and experimental studies is needed to determine whether or not this policy rule is preferable. In any event, the idea of a monetary policy that responds to toxic asset ratios is one worthy of careful consideration when setting out new post-crisis monetary policy rules.
* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the the December 14, 2009 issue of Kinzai Financial Weekly
