The standard theory of financial markets is based on the notion that markets are a reasonably effective mechanism for aggregating dispersed information about asset fundamentals, so that changes in observed prices correspond to changes in markets participants’ beliefs about future payment streams... The limitations of the standard approach to asset pricing have led to the development of theories built on frictions that cause market prices to deviate from the standard results. Some of these theories have the implication that market performance might be improved by central bank lending or other official intervention.
One commonly cited market malfunction is based on coordination failures that take the form of bank runs, especially runs that have the self-fulfilling property that market participants pull their funds simply because they think that others are doing so... My sense of the accumulated evidence is that it is hard to find examples of purely self-fulfilling runs — that is, runs not plausibly warranted by changing fundamentals.12 Not all rapid portfolio shifts represent runs that necessitate official intervention. Moreover, financial entities often can protect themselves from runs by structuring their borrowing arrangements appropriately.
Another type of market imperfection is the notion that asset prices can deviate from their fundamental values when some participants are forced to sell their holdings rapidly (to meet a margin call for example) and are forced to take whatever price is offered, even a price that commonly is known to be much less than the asset’s true economic value... In this age of integrated global financial markets, I find it hard to envision something — other than those investors’ doubts about the value of these assets — that has been artificially impeding investors’ entry into the markets for depressed assets.
A broader motivation for public sector support at times like these is the notion that credit market disruptions that reduce the banking sector’s capital can impede banks’ ability and willingness to extend credit to households and business firms, thereby creating an additional drag on spending and growth. .. My reading of the history of U.S. business cycles is that the direct effect of credit markets on real activity — the so-called “credit channel” — accounts for only a small part of the variation in output over the typical cycle. And my reading of current conditions is that bank lending is constrained more now by the supply of creditworthy borrowers than by the supply of bank capital.