We recommend the newly adorned Nobel winner’s hour-long presentation at this year’s AEA conference in January here.
The presentation was based on this paper, from which the abstract:
Money markets are fundamentally different from stock markets.
Stock markets are about price discovery for the purpose of allocating risk efficiently.
Money markets are about obviating the need for price discovery using over-collateralised debt to reduce the cost of lending. Yet, attempts to reform credit markets in the wake of the recent financial crisis often draw on insights grounded in our understanding of stock markets.
This can be very misleading.
The paper presents a perspective on the logic of credit markets and the structure of debt contracts that highlights the information insensitivity of debt. This perspective explains among other things why opacity often enhances liquidity in credit markets and therefore why all financial panics involve debt.
These basic insights into the nature of debt and credit markets are simple but important for thinking about policies on transparency, on capital buffers and other regulatory issues concerning banking and money markets.
FT Alphaville has already spilled an endless quantity of pixels on the topic of opacity, information insensitivity and money-ness (most recently here). For now we’ll just add that it was no surprise to see Holmstrom, at the beginning of his presentation, thank Gary Gorton profusely and cite Gorton’s work as a key influence.
And we have three recommendations for further reading on Holmstrom:
— David Warsh’s lengthy reflection* on the collaboration between Holmstrom and Gorton, in which Warsh also ruminates on Thomas Kuhn’s The Structure of Scientific Revolutions
— A critical view of this work from Synthetic Assets
— Tyler Cowen and Alex Tabarrok on all things Holmstrom
* We especially liked the closing passage from the Warsh post:
Kenneth Arrow, a brilliant theorist, recognized the potential significance of asymmetric information because he had studied to become an actuary as a young man. But neither Gorton nor Holmström knew enough by himself to spot the significance of opacity single-handed, much less had the capability to slowly map it into the consensus of technical economics at a high level.
Had Gorton not studied banking history for 25 years, so that he knew that new forms of bank money regularly are developed and recognized a panic when he found himself in its midst; had Holmström not studied organizations and information economics for 25 years; and had both not had considerable experience themselves in markets: they could not have made their contribution. The story of their collaboration, set against the twentieth-century economics that they learned in graduate school, makes an interesting tale.
So let’s say, here at the beginning, that this is a story about practice and theory and more practice and better theory in economics. It is a story about banks and central banks and why we have them. It’s a story about the relationship between the growth of knowledge and economic growth. It is, in other words, a history of economics since 2008.
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