How Revaluation (Mark to Market) Fuels Asset Price Cycles

[Joe Leote]

Figure 1 fig1a.gif (600×404) in this article on Integrated Macroeconomic Accounts shows the stock of Financial Assets and Liabilities:

FRB: Finance and Economics Discussion Series: Screen Reader Version - The Integrated Macroeconomic Accounts of the United States

This identity is taught in Introduction to Macroeconomics, typically designated ECON 102:

Saving = Net New Investment Spending + Government Deficit (Spending - Taxes) + Net Imports (Imports - Exports)

The Revaluation account in Figure 1 helps visualize, informally, how credit deals called net lending and borrowing fuel rising or falling asset prices. The assets created by net new investment spending are similar to older pre-existing assets on the aggregate balance sheets. Net lending and borrowing can be used for net new investment spending or to refinance the pre-existing assets at higher or lower prices. Assuming asset prices are set at the margin by the net lending and borrowing activity, then easy credit tends to bid up (inflate) asset prices with bullish credit deal flow (borrowers and lenders both expect rising asset prices in the Revaluation account) and tight credit tends to bid down (deflate) asset prices with bearish credit deal flow (borrowers and lenders both expect falling asset prices in the Revaluation account).

Hopefully, one can easily see that credit deals, financial savings, and changes in net worth in the real world do not correspond to the simple and inaccurate ECON 102 identity. There is a positive feedback loop between asset prices and net lending and borrowing, and there is lending and borrowing against pre-existing assets on the balance sheet that were not tied to net new investment spending. This is why credit deal flow and asset pricing is the key to understanding the stable trends and unstable episodes inherent in the macroeconomic system.

Joe