Knowing and Making

As often happens, Nick Rowe has communicated something tricky and difficult to understand in a limpid and revelatory way : ...the main proximate effect of monetary policy on AD is via Tobin's q -- when the price of existing assets rises relative to the marginal cost of producing new assets, firms will move along their MC curves and produce more new assets. Investment increases, in other words, and investment is a component of AD. And when the price of existing assets rises relative to the price of newly-produced consumption goods, both the income (wealth) and substitution effects lead households to increase their demand for newly produced consumption goods, and consumption is also a component of AD. This is such a good explanation of the fundamental mechanism of monetary policy that I virtually had to sit at my computer and applaud. Greg Random responds in the comments: Altering the flow and size of money streams changes the relative valuations of different asset classes, thro...

I promised more on the lemons discussion but Sandro Brusco has gone into more depth in this posting than I could have done in the time I had available yesterday. There's some way to go in analysing this, but Brusco has a couple of important points: The first is that the problem will only be solved by revealing information. He suggests doing this by requiring managers to make a personal investment in the assets, so they have an incentive to get the valuation right. As an alternative, I would consider simply publishing the detail of the assets so that third parties can look at what they consist of and make their own determination of value. Depending on the level of detail, this may raise privacy concerns for the original mortgage borrowers, so it won't be possible to publish absolutely everything. But I'm sure a lot could be released. The second is that the banking system can't function normally until this information is revealed, so it's critical to get it done soo...

Following up Geithner versus Darling by Robert Peston: There are three reasons why the assets held by banks (loans to weak borrowers, packaged in whatever way) might not be worth very much: The borrowers really can't (or won't) pay them back There is not enough liquidity so the banks can't sell them There is a "lemon" discount based on asymmetric information [ Updated ] Buyers or sellers of the assets are somehow irrational. I don't analyse this option in the article below but will try to work out for a future article whether it is a major factor. I am trying not to suggest a bounded rationality explanation for everything in the world! There is a huge argument going on about which of these is the real answer - because it has a bearing on which kind of bank rescue plan we should implement. If the answer is number 1, then the banks have screwed up and we may not want to throw more good money after bad by buying the loans. If the answer is number 2, we should be...

Robert Peston is looking back at the powers that the Bank of England should  have had to help forestall the asset price bubble of the last few years. It's an interesting angle, because it also sheds some light on the question of what powers the Bank should have now. He correctly points out that interest rates are too blunt a lever. When a central bank wants to be able to achieve multiple objectives - to do more than just target the inflation rate - it needs multiple tools. Interest rates are a two-sided tool - they can be raised in peak times to moderate activity, and cut in a recession to revive it. It's instructive to ask of any proposed solution: "does it work in reverse?" to see whether it meets this standard of having symmetrical power. The solution Peston discusses is adjusting the capital requirements of banks. In an asset boom, capital reserve requirements would be increased to reduce banks' ability or inclination to lend against assets. This would contro...