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MLAE Report Summary

Project ID: 230605
Funded under: FP7-IDEAS-ERC
Country: United Kingdom

Final Report Summary - MLAE (Money, Liquidity, and the Aggregate Economy)

The focus of John Moore’s research is on the difficulty borrowers face in convincing potential lenders that they will get repaid – that is, on the difficulty of writing credible financial contracts. In his view, the issue of commitment is at the root of why financial markets malfunction. Alongside other work he has completed for the project, he addresses four related questions:

First, he and Nobuhiro Kiyotaki revisit the old question: why does money exist? They develop a model of a monetary economy where there are differences in liquidity across assets. Money circulates because it is more liquid than other assets, not because it has any special function. There is a spectrum of returns on assets, reflecting their differences in liquidity. The model is used to examine what policies central banks might follow to change the mix of assets held by the private sector. The Kiyotaki-Moore model is seen as providing some intellectual underpinning for the kind of unconventional policy – purchasing private bonds, or credit easing – that has been undertaken in response to the financial crisis of 2007/8.

Second, Moore asks why illiquidity in financial markets may be contagious back through time. His starting point is that illiquidity stems from asymmetric information – in particular from the kind of ‘adverse selection’ that George Akerlof identified – and that adverse selection is contagious. On the one hand, suppose tomorrow’s market is not expected to fail. Then today’s buyer of an unknown asset will sell the asset tomorrow, whether or not it turns out that he bought a bad asset – in Akerlof’s terminology, a “lemon”. Thus, the only downside to buying a lemon today is that he suffers a one-time dividend loss. In other words, the difference in future payoff between a good asset and a lemon is small. But a small difference between the two implies that the market doesn’t fail today either. On the other hand, if markets in the future are expected to fail, then today’s buyer of an unknown asset will be stuck with it for a long time. Thus, the difference in future payoff between a good asset and a lemon is big. But a big difference between the two implies that the market fails today too.

Third, Moore builds a model of systemic failure in financial markets. Typically, financial intermediaries hold gross financial positions among themselves: they simultaneously borrow and lend to each other. The difference between a financial system with netting, and one without, is that the latter is susceptible to systemic failure: the failure of one intermediary to meet its debt obligations can cause other intermediaries to fail too. The question then naturally arises: what private benefit is there from holding such mutual gross positions, to offset the potential social and private costs of domino default? Moore’s answer rests on the idea that intermediaries are better placed than ultimate lenders (households) to monitor each others’ asset holdings, the debt owed by ultimate borrowers (entrepreneurs). As a result, stacks of lending arise: e.g., household 1, to intermediary 1, to intermediary 2, to entrepreneur 2; or, e.g., household 2, to intermediary 2, to intermediary 1, to entrepreneur 1. Notice in this case how intermediaries 1 and 2 hold mutual gross positions. At each level, in each stack, there is leverage. Such ‘Leverage Stacks’ explain why intermediaries choose to maintain their mutual gross positions, thus opening the door to systemic failure.

Fourth, Moore attempts to provide theoretical underpinnings for ‘Keynesian multipliers’ – the notion that government expenditure may boost private economic activity. Theoretical underpinnings for Keynesian multipliers have proved elusive. Moore believes that, here again, the root explanation is to do with the credit market, and the limited ability borrowers have credibly to promise to repay their loans.

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United Kingdom
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