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.
According to the followers of Knut Wicksell, the central bank must keep the market rate of interest near the natural rate of interest. No, said the followers of John Maynard Keynes, it must offset swings in business animal spirits in order to stabilize aggregate demand. On the contrary, said the followers of Milton Friedman, it must keep the velocity-adjusted rate of growth of the money stock stable. In fact, if you do any one of these things, you have done them all, for they are three ways of describing what is at bottom the same task and the same reality.