RIETI Report January 2010

A View on the Financial Crisis: Disappearance of money and contractions in aggregate demand provoked by the accumulation of bad assets

What Caused the Contraction in Aggregate Demand?

The Obama administration recently stated that its $787 billion stimulus package has worked and that the overall economy and employment were in better shape at the end of 2009, than they would have been without such a hefty package. Whether or not the stimulus package will be enough to ensure a sustainable recovery is an issue that is hotly debated by economists, with many Keynesian economists calling for continued expansionary fiscal measures.

This month's RIETI Report features a column written by RIETI Senior Fellow, Dr. Keiichiro KOBAYASHI, who questions the effectiveness of current fiscal spending by the Obama administration. Dr. Kobayashi looks at the root causes behind the contraction in aggregate demand in the U.S., following the Lehman shock, and suggests that fiscal spending aimed at accelerating the disposal of bad assets rather than spending designed to simply boost demand, could have a far greater impact on the economy.

This month's featured article

A View on the Financial Crisis: Disappearance of money and contractions in aggregate demand provoked by the accumulation of bad assets

KOBAYASHI KeiichiroSenior Fellow, RIETI
Visiting Professor, Chuo University
Research Director, Canon Institute for Global Studies

In this article, I will examine the U.S. economic policies implemented in response to the financial crisis. Today, we hear a great deal of Keynesian arguments calling for expansionary fiscal measures, as an indispensable means to pull the U.S. economy out of its slump, however, very few attempts have been made to identify the causes behind a severe contraction in demand. I believe that the contraction of aggregate demand might have been triggered by the disappearance of inside money resulting from the adverse selection due to information asymmetry (i.e. the problem of the market for lemons) caused by an increase in bad assets. If this is the case, fiscal stimulus measures alone will not have a lasting impact. Non-performing assets must be removed from the financial system to clear up the uncertainty. Only then, can aggregate demand in the U.S. economy achieve a sustainable recovery.

My discussion in this article is based on the analysis in Kobayashi (2009).

The Lehman shock in September 2008 has thrown the U.S. economy into serious recession, causing steep declines in employment and output. The recession has also had a significant impact on the academic community of economists. The Keynesian way of thinking, or the idea that a government can and should ease a recession by implementing macroeconomic policies such as boosting fiscal spending, has come to receive widespread support.

There is no doubt that the U.S. economy has been hit by a severe contraction in aggregate demand - i.e. a decrease in consumption and capital investment - following the Lehman shock. It is also obvious that the U.S. government needed to implement fiscal policies as an emergency measure to prop up employment. However, to what extent are Keynesian fiscal policies needed hereafter now that the panic has subsided? I would also imagine that it would be necessary for the U.S. government to review its current policies and compare them with other policy options.

To do so, first, it is necessary to identify factors that caused a contraction in aggregate demand in the United States after the financial crisis. Keynesian economists' arguments calling for fiscal expansion, lack analysis addressing the question of why U.S. aggregate demand is falling in the first place. What Keynesian economists have been insisting lately is that the government should pursue expansionary fiscal policies as an expedient measure to raise aggregate demand without questioning the underlying causes.

There are two possible ways of reasoning why aggregate demand decreased. One way is to see the contraction in aggregate demand as adjustments to excessive consumption resulting from the collapse of overly optimistic growth expectations for the U.S. economy in the future. The other is to see it as resulting from a failure in the financial system. I will focus on the latter as the main theme of this article. However, before proceeding to the main subject, let me briefly examine the first possible cause, i.e. adjustments to excessive expectations.

A negative wealth effect stemming from the loss of growth expectation

Prior to the financial crisis, extremely high optimism was widespread regarding the future growth of the U.S. economy. Very strong figures were predicted for both productivity and economic growth and it was considered that such growth expectations would justify the sharp rise in house prices observed at the time. An expectation of higher productivity for the U.S. economy generates an expectation of higher income, which leads to an expectation of higher house prices, and it is this expectation that drives up current housing prices. When house prices go up, American homeowners feel as though their assets have increased and become tempted to increase their present consumption. It is through such a mechanism that the bubble-like housing price boom occurred in the United States, but with the arrival of the financial crisis, the growth expectations underlying the boom were crushed. Even today, American economists are generally bullish about the growth prospect of the U.S. economy, but they are not optimistic to the point that they expect U.S. house prices to quickly recover to pre-crisis levels. With housing prices and related real estate properties down, it is felt that American households are experiencing a negative wealth effect, i.e. a contraction in demand resulting from declines in asset values.

If such a negative wealth effect has been causing the contraction in aggregate demand in the United States, temporary adjustments are an inevitable phenomenon. That is, it is unavoidable for the economy to undergo certain adjustments, namely, the removal of excessive capital stock that has been built up based on erroneous forecasts, cutbacks in consumption, and the streamlining of employment. Such an adjustment process would not last long and the economy should be able to self-restore its strength in due time. In such a case, it is considered that a Keynesian fiscal policy is an effective policy response as a measure to address immediate problems or mitigate the pain accompanying any such sudden drastic changes.

However, U.S. data suggest that a negative wealth effect is not the sole cause. We now need to focus on the changes in the labor wedge shown in figure 1 . The labor wedge is an indicator defined as the ratio of the marginal rate of substitution of consumption for leisure (MRS) and the marginal product of labor (MPL). The labor wedge is 1 when there is no distortion in the labor market, and it declines when there are greater distortions. What should be noted is that the labor wedge does not change simply because of the loss of growth expectations. As shown in figure 1 , the labor wedge for the U.S. economy declined sharply after the Lehman shock in 2008. This suggests that certain market distortions in the U.S. economy were compounded after the financial crisis.

Figure 1: Changes in the Labor Wedge Figure 1: Changes in the Labor Wedge click to elarge
(Source)Bureau of Economic Analysis, Home Page of Cociuba, Prescott, and Ueberfeldt

Typical market distortions that induce a deterioration of the labor wedge include a rise in labor taxes and an increase in the costs of job searching. However, it is known that an increase in liquidity constraints, a phenomenon in which households are unable to spend and/or businesses are unable to pay wages due to being cash-strapped, also causes an aggravation of the labor wedge. The deterioration of the labor wedge shown in figure 1 suggests that increased liquidity constraints resulting from the financial crisis may have caused a profound impact on macroeconomic performance in the United States.

Bad assets and the disappearance of inside money

In his lecture on the current U.S. recession delivered at Seoul National University in September 2009, Robert Lucas, a University of Chicago professor and winner of the 1995 Nobel Prize in economics, presented an analysis that explains the essence of the crisis concisely and precisely. The key points of his argument can be summarized as follows:

A financial crisis is the disappearance of inside money caused by a mechanism similar to that of bank runs. As an outcome of the disappearance of money, both households and businesses have come to lack means of payment (inside money) and thus become unable to buy goods and labor, resulting in a decrease in consumption and capital investment. That is, the disappearance of money caused a demand deficiency.

Indeed, as argued by Professor Lucas, short-term borrowings - including commercial papers (CPs) and repurchase agreements (repos) - from the interbank market declined sharply in 2008. To be sure, the money supply measured in terms of M2 has not decreased, but if we consider CPs and repos issued by financial firms as part of the broadly-defined inside money, we can observe a sharp decrease in the supply of inside money in the entire U.S. economy. This point has been emphasized by researchers at the Federal Bank of New York as well as monetary economists including Princeton University Professor H. S. Shin. When the interbank market is disrupted, it becomes difficult for business corporations to issue bonds and CPs, causing serious cash flow problems for companies and hence contractions in employment and production. Such is the process that has actually occurred in the U.S. economy. Disruptions in payments in the United States are observable in figure 2 , which shows changes in the value of transfers over the Fedwire, a real time gross settlement funds transfer system operated by the Federal Reserve Banks. As shown in the figure, the value of transfers dropped sharply in 2008 and thereafter. It is considered that the malfunctioning of financial intermediation has caused disruptions in transactions in the real economy, thereby undermining the entire economy.

Figure 2: Changes in the value of transfers in the United States Figure 2: Changes in the value of transfers in the United States click to elarge

This view is consistent with the aforementioned deterioration of the labor wedge in the U.S. economy (it should be noted that the labor wedge deteriorates when financial constraints increase). Provided that this view of seeing the large-scale disappearance of inside money as causing the contraction of aggregate demand in the U.S. economy is correct, the question is what caused the disappearance of inside money. If we can trace down such causal factors, we will be able to stop the declining trend of aggregate demand and turn it into an upward trend. Achieving this end requires policies that are quite different from conventional fiscal policies exemplified by public works projects and tax breaks.

The key problem seems to have been counterparty risk - i.e. the risk that the party at the other end of a transaction defaults on its obligations - in the financial markets. Professor John Taylor of Stanford University said that the importance of counterparty risk caught his attention in 2007. As it appears, the term "counterparty risk" is being used in a range of different meanings. For the purpose of this article, I use this term synonymously with George Akerlof's market-for-lemons problem (which is, according to my understanding, how Professor Taylor defines the term). The problem of the market for lemons is a phenomenon described as follows: when both good assets and bad assets are sold in the same market and there is an information asymmetry between sellers and buyers regarding the quality of assets (i.e. the sellers know the quality of their assets being sold whereas the buyers are unable to distinguish between the good and bad), good assets disappear leaving only bad assets in the market. The phenomenon is identical to that described by Gresham's Law as "bad money drives out good," and the resulting consequence is a collapse of the asset market. Inside money is short-term debt securities issued by financial firms, meaning that the value of inside money is backed by the assets held by those financial firms. Thus, when the market for financial assets collapses, inside money disappears.

In the latest financial crisis, the collapse of the U.S. housing bubble triggered the accumulation of massive bad assets (mortgage backed securities). Thus it can be perceived that the presence of these bad assets caused a market-for-lemons problem, resulting in the disappearance of inside money on a nationwide scale (many economists, including Beaudry and Lahiri (2009), hold a similar view).

If such a disappearance of inside money was the primary cause of the contraction of aggregate demand, and if the disappearance of inside money had occurred in the process of adverse selection, as in the market for lemons, induced by the accumulation of bad assets, the most straightforward way to boost aggregate demand is to remove bad assets from the market. For instance, one possible policy option for the U.S. government is to purchase bad assets from the market using federal funds. This would eliminate the information asymmetry that remains persistent in the market, thereby bringing the downward trend of demand to an end and putting the U.S. economy on a sustainable recovery path. Needless to say, this is no easy task because, even as the government works to remove bad assets from the market, new layers of bad assets will be added with the deepening of the recession. Nevertheless, this approach will be far more effective than conventional demand-boosting measures such as spending on public works projects.

In a situation where information asymmetry arising from the presence of bad assets is the primary cause of problems, simplistic Keynesian remedies can only have a temporary effect. So far as huge sums of bad assets remain in the market, the problem of the market for lemons continues and there is no stopping the disappearance of money.

Therefore, arguments made by some economists that simply stress the need to provide fiscal stimulus are somewhat misleading. In the light of my analysis discussed above, the use of fiscal funds targeting measures to remove bad assets from the market can have a far greater policy impact than fiscal expenditures designed to boost demand in general. The U.S. government seems to be poised to use its funds earmarked for the Troubled Asset Relief Program (TARP) for Keynesian fiscal measures such as those for creating and maintaining jobs. Is this the right policy decision? What the U.S. government should be doing instead is to accelerate the disposal of bad assets by taking up a hard-line stance on financial firms and implement measures to facilitate the government's purchase of bad assets. That way, the U.S. government would be able to expedite the recovery of its economy.

The U.S. government is quite confident of macroeconomic recovery. But we still need to carefully observe the performance of the U.S. economy in 2010 - particularly the movements of the labor wedge as well as of payment activities, a measure of which is the value of transfers over the Fedwire - before coming to anything conclusive.


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