3. Role of Asset Markets in Business Cycles: (1) Collateral Role of Assets

We discuss the roles played by the asset markets in business cycles. In particular our interest lies in whether the increasing weight given on the asset market in the economy magnifies the business fluctuations or not. In general the asset prices fluctuate more than the real variables, as is typically observed in the current recession and the preceding booms. The problem is whether the volatility of asset markets is propagated to the real economy. If the answer is yes, then much of the current business fluctuations are attributed to those in the asset prices. We discuss this problem from two viewpoints. One is the collateral role played by the asset values, especially land value. The other is a signaling role played by the stock market. In this section we discuss the first problem and the second one will be dealt with in the next section.

According to the celebrated Modigliani-Miller theorem, There exists no difference in cost between the internal funds and the external funds and therefore the level of investment is independent of the financing method. $ ^{2)} $ However Doubt has been cast on the validity of the fundamental assumptions underlying the theorem since the theorem came into being. The assumption of perfect information has been often criticized as unrealistic and growing attention has been paid to an alternative assumption of the asymmetric information between creditors and debtors. It is quite natural to assume that the corporations as a borrower has superior information on the investment projects to be undertaken to lenders. Furthermore the lenders cannot monitor the behavior of the borrowers perfectly without incurring additional costs. Then there arises the well-known principal-agent problem. In those situations the optimal financial arrangements will be made between the lenders and the borrowers that include the clauses that prevent the borrowers from taking actions disadvantageous to the lenders. However it is demonstrated that the level of investment by the corporations becomes inefficient compared to that without any informational friction due to the costs arising from the financial arrangements.

This cost drives the wedge between the cost of internal funds and that of the external funds. The upshot is that the investment decision is no longer independent of the method of raising funds. The cost of internal funds is cheap relative to that of external funds. Therefore the abundance of internal funds induces the corporations to undertake more investment projects. Recently this argument is further elaborated and it is shown that what reduces the agency costs is the collateralizable net worth of the borrowers. In other words the information regarding the balance sheets of the debtors plays a vital role in determining the level of investment. $ ^{3)} $ The larger the collateralizable net worth is, the higher the level of investment is. Emphasis on the net worth in investment decision has important implications to the business fluctuations. Combining the fact that the asset prices move procyclically with the positive dependence of investment on the level of collateralizable net worth, it can be deduced that the fluctuations of investment will be magnified and thus the volatility of business cycles will be amplified.