Imperfect Knowledge, Liquidity and Bubbles

This paper demonstrates that insufficient liquidity, in the form of a shortage of safe assets that are useful as collateral in facilitating exchange, can lead to substantial movements in asset prices. There is a single asset that yields a positive payoff stream and can be traded in a centralized market. The asset can also be used to facilitate exchange in decentralized, or over-the-counter, trade and if the asset is in sufficiently short supply the fundamental asset price includes a liquidity premium. Traders, though, have imperfect information about the future price at which the asset will trade and so they behave like a Bayesian who estimates an econometric forecasting model for the asset price that is updated in real-time via discounted least-squares. The paper has three primary results: first, a permanent decrease in the supply of safe assets can lead to a substantial over-shooting of the asset price from its fundamental value; second, an increase in collateral requirements can lead to a substantial overshooting of asset prices; third, when asset prices include a liquidity premium there can be recurrent bubbles and crashes that arise as endogenous responses to economic shocks. The world has a shortage of financial assets. Asset supply is having a hard time keeping up with the global demand for store of value and collateral by households, governments...The equilibrium response of asset prices and valuations to these shortages has played a central role in ... the recurrent emergence of speculative bubbles, the historically low real interest rates ... all fall into place once on adapts this asset shortage perspective. – Ricardo J. Caballero in “On the Macroeconomics of Asset Shortages.”