J. Bradford DeLong
For more than 170 years, it has been accepted doctrine that markets are not to be trusted in a liquidity squeeze, and for roughly the past 85 years, central banks have set the price of liquidity in financial markets even in normal times. Now, with America's proposed $700 billion financial-sector bailout, the price of risk, too, will be administratively set.
BERKELEY – For more than 170 years, it has been accepted doctrine that markets are not to be trusted when there is a liquidity squeeze. When the prices of even safe assets fall and interest rates climb to sky-high levels because traders and financiers collectively want more liquid assets than currently exist, it is simply not safe to let the market sort things out.
At such a time, central banks must step in and set the price of liquidity at a reasonable level – make it a centrally-planned and administered price – rather than let it swing free in response to private-sector supply and demand. This is the doctrine of “lender-of-last-resort.”
For more than half that time – say, 85 years – it has been accepted doctrine that markets are also not to be trusted even in normal times, lest doing so lead to a liquidity squeeze or to an inflationary bubble. So, central banks must set the price of liquidity in the market day in and day out.
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