Asymmetric information

Asymmetric information reflects a view among New Keynesian economists that allows for incomplete markets on account of the fact that principal and agent do not possess the same degree of information about a particular event or state. This perceived infor- mational asymmetry weighs heavily on the New Keynesian credit-channel theory of the monetary policy transmission mechanism, based on the loanable funds view of the rate of interest, whereby the real rate of interest acts as a price-rationing device to equilibrate the supply and demand for loanable funds. New Keynesians acknowledge that the real rate of interest may not perform this equilibrating function when the demand for loanable funds rises beyond certain levels. Lenders may withhold credit to otherwise creditworthy borrowers rather than offering loans at higher rates of interest even if these borrowers would be willing to pay those higher rates. Money neutrality is violated as the predicted link between changes in high-powered money and the money stock is upset. Output and employment are then less than their full-employment counterparts.

The source of this low-level equilibrium in the credit market is attributed to what Dymski (1998, p. 21) calls "the asymmetric distribution of information between incentive-incompatible principal and agent, together with an exogenous source of risk" (see Stiglitz and Weiss, 1981 and 1992). Lenders cannot trust that they have the same information about the viability of loans as do those to whom they are lending; perceived information is then asymmetric. Lenders cannot know the expected marginal product of potential investment projects with the knowledge held by borrowers. They worry that increased demands for "loanable funds" that prompt rising interest rates may cause cred- itworthy borrowers to drop out of the market for these funds, leaving a pool of potential borrowers who may engage in riskier projects with higher probabilities of failure (adverse selection and incentive effects).

Suppliers of "loanable funds", who have less information about the prospective yields on these projects than the demanders, worry that the likelihood of non-repayment could heighten. This perceived increase in default risk might put the risk composition of bank portfolios in jeopardy of irretrievable capital loss. The rational strategy for them under such circumstances is not to lend to these demanders of loanable funds at higher rates of interest, but instead to deny them the ability to borrow these funds; that is, to use quantity rather than price as the credit-rationing device.

Among the consequences of this credit rationing on account of perceived asymmetric information are distributional concerns (small businesses that do not have access to other forms of finance except bank loans are crowded out of the market for loanable funds) and macroeconomic concerns in the form of effective supply failures (firms that could otherwise sell produced output cannot gain access to finance to initiate that production) (see Blinder, 1987; Stiglitz and Greenwald, 2003).

Seen in a larger context, the idea of asymmetric information as the decisive factor in the clogging of finance and output markets is simply not persuasive. What is significant, instead, is the pervasive sense among all market participants that the future is uncertain, and not reducible to individual risk calculations (see Dow, 1998; Dymski, 1998; Isenberg, 1998). This type of uncertainty stems from the fact that individuals cannot know the prospective yields on whatever assets they may purchase (either real or financial). The prospective yield on any asset is not merely a function of its marginal productivity (in the case of a capital asset) or its marginal productivity once removed (in the case of a financial asset purchased to underwrite the capital expenditure). The return on such assets is also a function of the number of other individuals who engage in such activities and of the perceptions of individuals on the outcomes of those prospective activities. Uncertainty in this sense is a socially-constructed phenomenon internalized by individu- als. The conditions underlying the supply and demand for so-called loanable funds are interdependent, not capable of deconstruction into separate individually-founded supply and demand functions mediated by some real rate of interest. This common behaviour, whether it be financial institutions sitting on cash reserves or firms sitting on retained earnings (both evidenced in the aftermath of the Great Recession of 2007-09), is moti- vated by a desire to remain liquid in light of an uncertain future, what Keynes identified as liquidity preference (Keynes, 1936; see also Bibow, 2006).

Moving beyond the narrowly defined New Keynesian framework of credit rationing based on asymmetric information about borrowers' and lenders' risks makes myopic and one-sided the case for effective supply failures as the primary factor in the explanation of low-level economic activity (see Rotheim, 2006). A more general framework based on the pervasive nature of uncertainty requires a general theory of effective demand, as was laid down by Keynes (1936), where employment and output for the economy as a whole reflect the interaction of effective supply and demand, each determined by employers' expectations of prospective revenue associated with any level of employment. Finance and access to finance are critical factors in understanding the ability of firms to effectuate these employment decisions. Access to external finance and the decision to engage inter- nal finance rely on an accommodative central bank as well as the liquidity preferences of firms and financial institutions (banks and shadow banks).

See also:

Credit rationing; High-powered money; Liquidity trap; Monetary policy transmission channels; Money neutrality; Shadow banking; Yield curve.