Asset price collapses, banking crises and recessions (Werner 2005)

Instances of asset inflation are not welfare optimal. For one thing, it cannot be considered efficient nor equitable when new claims on finite resources are created by banks and then granted to a specific group of individuals who use them purely for speculative gain, without adding to productivity or output. Moreover, the extension of speculative loans and asset-collateralizing loans creates negative externalities in the economy and thus directly affects others. If house prices are driven so high that they are beyond the reach of first-time buyers, this can affect the quality of life of entire communities. In England, many cities are unable to attract sufficient numbers of welfare workers, teachers or firemen, as they cannot afford to live in them on their salaries. High real estate prices in city centres may increase commuting times and hence shorten the time available for family or leisure.

The externalities in the banking system are also significant: as banks become overextended to borrowers who have not invested the newly created money productively, our theory of productive credit creation tells us that, in aggregate, such loans cannot be paid back (only ‘productive’ loans will be non-inflationary and only ‘productive’ loans will produce goods and services of value, thus producing income to service the loans). As a result, systemic risk increases.

Bank lending for speculative purposes CF is only viable as long as banks continue to increase such lending. It seems a reasonable assumption that banks will not continue to increase their speculative lending CF into eternity. We thus consider what happens when at some stage (perhaps again induced by a regulatory shock, such as a change in the monetary policy of the central bank) CF  falls. According to equation (5), asset prices will fall. This will then reduce collateral values and bankrupt the first group of speculative borrowers who were seeking merely capital gains. Their default will create bad debts in the banking system. This in turn will raise banks’ risk aversion and reduce the amount of credit newly extended. This further reduces asset prices (equation 5), which increases bankruptcies. The process can easily make banks so risk averse that they also reduce lending to firms for productive purposes, in which case GDP growth will also fall (equation 4). Such credit crunches have been observed in many cases, including the US.[2] This exacerbates the vicious cycle, since with less economic growth, corporate sales and profits decline. As more firms become unstable, bad debts increase further (see Figure 16.1). [emphasis added] (Werner 2005)

16.1

Reference

Richard A. Werner, New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic Performance, (Houndmills, Basingstoke, Hampshire: Palgrave Macmillan, 2005), 229-230.

Footnote

[2] For empirical evidence of the credit crunch problem in Japan see, for instance, Matsui (1996). On the US see, for instance, Gertler and Gilchrist (1994).

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One thought on “Asset price collapses, banking crises and recessions (Werner 2005)

  1. One avenue to encourage the good kind of productive bank lending is through modifications to the Basel III rules that specify the “risk weight” that loan assets receive. These risk weights define the charge against the bank’s capital that each loan consumes. Retail small business lending receives a 100% risk weight, which is high, whereas a government bond receives a 0% weight. So if productive loans could be given a very low risk weight so that they don’t hurt bank capital ratios while speculative non-productive loans were given a high risk weight, regulation could be used to guide the economy back towards a more productive stable footing and away from serial credit crunches and asset bubbles.

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