Financial Engine Failure - Essay Example

Also, the waning corporate net worth has increased moral hazard inducements for companies to make risky investments because they now have less to lose. Again this increase in moral hazard makes lending less attractive. The failure of financial institutions in the mortgage debacle, together with the drop in the stock market has led to uncertainty in financial markets. It is more difficult to determine good from bad credit, which again has resulted in a fall in lending, investment, and cumulative activity.

The source of the current bank panic, therefore, is asymmetric information. The result is that loan funds have been reduced and the price of intermediation has risen, which has caused a drop in investment and a decline in aggregate economic activity (Mishkin). The current bank panic could lead to further interest rate hikes, which would, in turn, increase adverse selection in financial markets, which is why the Feds have cut interest rates. The current unforeseen fall in the price level has also resulted in a decline in firms' real net worth and an increase in adverse selection and moral hazard problems facing lenders.

This in turn has resulted in a decline in investment and economic activity. The asymmetric information approach also favors an expanded lender-of-last-resort role and a discounting facility (Mishkin), which would provide liquidity to the financial sectors that most need it. The Feds have tried to hold back 'the credit crunch' but now we need to see how far they will go. Will they lower interest rates further even though they do not have as much room as in the past to cut Will they provide the much-needed liquidity to the financial sector, In other words, are they able to bail America out of a recession.