Asset Market Effects on Balance Sheets

Question

I am currently using Mishkin's textbook "Economics of Money, Banking and Financial Markets." The chapter on financial crises starts with the causes of financial crises.

One reason given is the Unanticipated Decline in the Price Level. I quote "In economies with moderate inflation, which characterize most industrialized countries, many debt contracts with fixed interest rates are typically of fairly long maturity (ten years or more). In this institutional environment, unanticipated declines in the aggregate price level also decrease the net worth of firms. Because debt payments are contractually fixed in nominal terms, an unanticipated decline in the price level raises the value of borrowing firms' liabilities in real terms, but does not raise the real value of firms' assets."

I get that as the value of money is increasing over time (deflation), the real value of the debt is increasing. What is the reason for asset values to not be rising? If the nominal value of the assets stay the same, then assets will be rising in real value (as money is becoming more valuable). Am I missing something obvious?

Answer 1

The textbook assumes that assets are real assets (inventory, equipment, etc.) that are falling in nominal value along with the price level. However, this will not be the case for financial firms, as their assets are almost always fixed nominal loans. So there is an embedded assumption that this only refers to non-financial firms, which is not specified in the quote provided. (Note that “borrowers” does not imply non-financial, since financial firms are major borrowers.)

However, this is a questionable reason to explain a financial crsis. No firm revalues assets or liabilities based on changes to the price level. The real concern is that falling prices imply falling nominal revenues, which are matched against fixed nominal debt payments. So it’s not really the balance sheet value, rather the prospective value based on future profits that are shrinking. In other words, the problem shows up in the income statement, not the balance sheet.

On paper, accounting values are supposed to reflect prospective profits, but in practice, continuous revaluations are not part of accepted accounting procedures. An asset has to be obviously impaired before being written down. Therefore, balance sheet revaluations (other than loan losses) are not the driver of a financial crisis.