Arnold Kling  

Should We Penalize Liquidity Preference?

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Greg Mankiw says that it is time to re-read Keynes, and Tyler Cowen is ready to take him up on it.

One important Keynesian idea is liquidity preference. In textbooks, an increase in liquidity preference means that people want to hold money rather than bonds. This drives up interest rates and slows the economy.

In the contemporary economy, the increase in liquidity preference shows up as a demand for Treasury bills. The interest rate on Treasuries actually gets driven down, while the interest rate on other assets goes up. If you measure the risk premium as the spread of other rates over Treasuries, the risk premium is in the stratosphere. For example, a friend in the auto industry told me that AAA-rated securities backed by auto loans were trading at 1200 basis points over Treasuries. So if the Treasury was 2.5 percent, the auto security was yielding 14.5 percent. Yes, I know that nobody believes that AAA means risk-free any more, but still...

I'm trying out the following metaphor. Picture a gambling casino with a lot of poker tables, where suddenly the players are becoming wary of one another. Some of them start pointing fingers at one another, saying, "I don't think you have the money to cover your bets. I demand that you give me cash now to hold as collateral, in case I win my bet against you."

Pretty soon, everyone is reaching into each other's pockets, grabbing for cash, and all order breaks down. You have a riot taking place. (The real world analog is everyone demanding lots of collateral from their counterparties in repurchase agreements, credit default swaps, and so forth, and everyone only accepting Treasuries as collateral. Thus, we have a big institutional increase in liquidity preference.)

Given this sort of riot, my preferred solution would be to introduce a stern sheriff (played by John Wayne), who says, "Boys, siddown and shuddup. We're gonna straighten everything out here, but y'all are gonna have to just wait. Everybody who is patient and waits until these things are sorted out will get most of what's coming to them. But anybody who gets antsy and starts grabbing for liquid assets is going to get a whole lot less."

In less metaphorical terms, I think that the people who insist on Treasuries as collateral should have to pay a financial penalty, just as someone who has a CD at a bank can be assessed a penalty for early withdrawal. By punishing liquidity preference, we could stop the liquidity squeeze.

This is analogous to my idea for an uninsured bank stopping a bank run. The bank can have policies that impose penalties for cash withdrawals that rise as the bank's liquidity position deteriorates.

Instead, Bernanke and Paulson are running around with bags of money trying to satisfy the demands for liquidity. They keep offering to cover the bets of the gamblers--Bear Stearns, AIG, Citgroup, and others. I think this helps to feed the mindset that is causing the riot. It gives those with extravagant liquidity preference what they want--encouraging others to adopt a "grab it while you can get it" mindset. Bernanke and Paulson are agitating the riot, not quelling it. I would punish liquidity preference, not reward it.


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COMMENTS (8 to date)
MattYoung writes:

I presume you are kidding

Alex Tabarrok writes:

Of course you are correct - when it was a flight to cash that was the point of inflation so now we need a tax on T-bills.

Eddy Elfenbein writes:

Why don’t we try to profit off the liquidity preference by issuing massive amounts of T-bills in order to buy high-yielding preferreds in locked-up companies?

El Presidente writes:

You're right that Bernanke and Paulson are trying to quench the thirst for liquidity. I don't know that that's all bad, but there is more than one way to do it and I feel they have not settled on the best way. Basically, they have to redistribute directly, as through taxing and spending, or indirectly through inflation of one kind or another. They have several choices of how to inflate and so far they are still trying to cram money in through the top and hope it reaches the bottom. It won't work. It needs to flow the other direction. If the money goes in the bottom, they can have better control of it when it reaches the top to slow the inflation down once the system is stable again by drawing out excess liquidity.

I do agree that the safe haven provided by government instruments tends to worsen the flight; makes it more extreme. That's why budget deficits are so treacherous under anti-inflationary monetary policy; they add to the amount of debt the government issues which, intentionally or not, creates a haven for people who would rather hold bonds than pay taxes, thereby reinforcing the upward momentum of money. This is why I'd say people give Greenspan a much worse beating than he deserves. If the budget is held in balance, or reasonably so, you can get away with Greenspan's monetary policy. When you change fiscal policy, you must also change monetary policy to avoid our current predicament.

Bill Woolsey writes:

Part of the "problem" here is that the major money center banks believe that they should be able to borrow at something close to the Treasury Bill rate. They need to give up their sense of entitlement. More importantly, there is no reason for this to be a policy goal. Perhaps the interest rate that money center banks must pay is too high for macroecomic equilibrium. It seems likely that an incease in the interest rate they must pay because of greater perceived risk requires lower interest rates in general. It also seems likely to me that having them pay more, others pay less, and interest rates being lower in general would be just about right. Having T-Bills rates being low isn't the problem.

The only possible problem is that if nominal interest rates on some financial instruments start getting constrained by the lower bound of zero. And then the problem is nothing specific to T-Bills, but rather zero-interest currency.

If people want T-bills, then let their prices rise (and their yeilds fall) to clear the market.


Jim Pinney writes:

There is a paper which explains and goes into the details of the mad dash for liquidity under Knightian uncertainty which fits these facts real well: http://www.nber.org/papers/w11834

Financial System Risk and Flight to Quality

and the solution (I think) is government insurance of the tail risk - the Knightian uncertainty of the destruction of the financial system - as proposed by Larry Kotlikoff et al in the FT economists forum Oct 26 - Recapitalising the Banks is not Enough.

David Becker writes:

Pre-FRS, banks would suspend withdrawals during liquidity crunches (eg 1907 Knickerbocker crisis). Coversion of deposits to cash was limited in frequency and duration across a city/region.

So damping liquidity preference has been done before. Not sure how the effect could be engineered these days.

tv writes:

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