3/19/2008: Act now to stop the markets' vicious circle

Excerpts from Act now to stop the markets' vicious circle
By Paul De Grauwe, Professor of Economics at the University of Leuven

This perverse co-ordination by the market (some will call it a vicious circle) is made worse by "marking to market" (valuing assets at market rates). The practice forces banks to take a loss on their balance sheets on assets that are caught by the liquidity-solvency spiral. They are forced to do so even if these assets are sound. Thus marking to market today accelerates the downward spiral. Marking to market, which was generalised as an accounting procedure in the 1990s, was influenced by the idea that financial markets are efficient. In this view markets provide the best method to put a correct value on financial assets. Markets are wiser than the judgment of individual bankers or accountants, it was said. That is right under normal circumstances, but not today, when markets are clearly driving towards a bad equilibrium. Markets are not always right.

Today the accounting rule of marking to market is driving us at high speed into the abyss. A speed limit must be imposed. It can be achieved only by temporarily allowing financial institutions not to mark to market. This will make it possible to keep the assets on their books for a while at their previous values (or historic costs). If this is done, the spiral will be slowed down. Prices of many financial assets will recover because they are fundamentally sound. Their value is artificially pulled down by the liquidity-solvency spiral.