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.
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.
Thus, as social democracy, government guideposts, and centralized planning waxed and waned elsewhere in the economy, social democracy in short-term finance went from strength to strength. First, central banks suspended the rules of the free market in liquidity squeezes. Then they set the price of liquidity as an administered price in normal times. Then they freed themselves of all but the lightest contact with their political masters: they became independent technocrats, a monetary priesthood that spoke in Delphic terms obscure to mere mortals.
The justification for this system was that it seemed to work well – or at least less badly than central banking that blindly adhered to the gold standard or no central banking at all. This island of central planning in the midst of the market economy was a strange and puzzling feature – all the more so because so few remarked how strange it was. There were no calls for a five-percent-growth-of-kilowatt-hours rule as there were calls for a five-percent-growth-of-M2 rule. There was no Federal Automobile Board to set the price of vehicles the way the Federal Reserve Board set the price of federal funds.
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But now it appears that, despite all this, we still have not had enough central planning in finance. For, even as the central banking authority administered the price of liquidity, the price of risk was left to the tender mercies of the market. And it is the price of risk that is the source of our current distress.
It is not that the world economy faces a liquidity squeeze. Far from it: two-year United States Treasury notes with a face value of $1,000 will get you $998 in cash – the lowest liquidity price since the Great Depression and Japan in the 1990’s.
Yet the risk premia on non-Treasury assets have soared to barely believable heights: the annual interest-rate premium for holding a CD issued by a private bank now stands at five percentage points. And it is this rise in risk premia that threatens to send the global economy into a deep recession, and turn the financial markets from a spectacle of schadenfreude into a malign source of unemployment and idle factories worldwide.
The US Federal Reserve, the US Treasury, the European Central Bank, the Bank of England, and other public financial regulatory entities are being pushed toward a further expansion of their roles. The Treasury and Federal Reserve are adding preferred stock to the balance sheets of the US mortgage giants Fannie Mae and FHLBC and the insurance giant AIG in the hope of shoring up their capital cushions and lowering their borrowing costs so that they can buy more mortgages.
The Treasury has asked for authority to purchase $700 billion of mortgages to get them off of the private sector's books. Expanding the demand and reducing the supply of these risky assets is a way of manipulating their price. The Fed and the Treasury are walking down a road that ends with making the price of risk in financial markets, along with the price of liquidity, an administered price.
This was how central banking got started in the first place: letting the market and the market alone determine the price of liquidity was judged too costly for the businessmen who voted and the workers who could overthrow governments. Now it looks as though letting the market alone determine the price of risk is similarly being judged too costly for today’s voters and campaign contributors to bear.
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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.
Thus, as social democracy, government guideposts, and centralized planning waxed and waned elsewhere in the economy, social democracy in short-term finance went from strength to strength. First, central banks suspended the rules of the free market in liquidity squeezes. Then they set the price of liquidity as an administered price in normal times. Then they freed themselves of all but the lightest contact with their political masters: they became independent technocrats, a monetary priesthood that spoke in Delphic terms obscure to mere mortals.
The justification for this system was that it seemed to work well – or at least less badly than central banking that blindly adhered to the gold standard or no central banking at all. This island of central planning in the midst of the market economy was a strange and puzzling feature – all the more so because so few remarked how strange it was. There were no calls for a five-percent-growth-of-kilowatt-hours rule as there were calls for a five-percent-growth-of-M2 rule. There was no Federal Automobile Board to set the price of vehicles the way the Federal Reserve Board set the price of federal funds.
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Access every new PS commentary, our entire On Point suite of subscriber-exclusive content – including Longer Reads, Insider Interviews, Big Picture/Big Question, and Say More – and the full PS archive.
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But now it appears that, despite all this, we still have not had enough central planning in finance. For, even as the central banking authority administered the price of liquidity, the price of risk was left to the tender mercies of the market. And it is the price of risk that is the source of our current distress.
It is not that the world economy faces a liquidity squeeze. Far from it: two-year United States Treasury notes with a face value of $1,000 will get you $998 in cash – the lowest liquidity price since the Great Depression and Japan in the 1990’s.
Yet the risk premia on non-Treasury assets have soared to barely believable heights: the annual interest-rate premium for holding a CD issued by a private bank now stands at five percentage points. And it is this rise in risk premia that threatens to send the global economy into a deep recession, and turn the financial markets from a spectacle of schadenfreude into a malign source of unemployment and idle factories worldwide.
The US Federal Reserve, the US Treasury, the European Central Bank, the Bank of England, and other public financial regulatory entities are being pushed toward a further expansion of their roles. The Treasury and Federal Reserve are adding preferred stock to the balance sheets of the US mortgage giants Fannie Mae and FHLBC and the insurance giant AIG in the hope of shoring up their capital cushions and lowering their borrowing costs so that they can buy more mortgages.
The Treasury has asked for authority to purchase $700 billion of mortgages to get them off of the private sector's books. Expanding the demand and reducing the supply of these risky assets is a way of manipulating their price. The Fed and the Treasury are walking down a road that ends with making the price of risk in financial markets, along with the price of liquidity, an administered price.
This was how central banking got started in the first place: letting the market and the market alone determine the price of liquidity was judged too costly for the businessmen who voted and the workers who could overthrow governments. Now it looks as though letting the market alone determine the price of risk is similarly being judged too costly for today’s voters and campaign contributors to bear.