In 1970 George Akerlof wrote a seminal paper called “The Market for Lemons” which describes how the market for used cars can seize up if there are enough bad used cars (“lemons”) out there and if prospective buyers can’t tell lemons apart from good cars. In that situation there may be no price low enough for buyers to want to buy a used car and the market goes away. Used cars were simply an example for any market with a strong information asymmetry (this is what Akerlof, Michael Spence and Joseph Stiglitz eventually won the Nobel in Economics for in 2001).
We currently have a “Market for Lemons” in credit. If there are enough bad borrowers out there (i.e. borrowers that could go belly up) and if lenders can’t tell good borrowers from bad borrowers (because of impossible to value exposures), then lending will simply go away. There is no rate that is attractive enough to entice the lenders to lend.
That is where we are at in many credit markets today and it makes the Fed powerless. When the Fed lowers its rates or otherwise makes it easier for banks to access money that they could lend out this does nothing to improve the information asymmetry. As a result, even though banks could now make money more easily by lending to good credits if they can’t tell those good credits apart from the bad ones the market will not budge.
