Arnold Kling  

Timing the End of the Liquidity Crisis

Allowing A Positive Price for ... Paul Krugman on IS-LM...

Tyler Cowen writes,

By the time the three years is up, a lot of these institutions will have been nationalized, if only de facto.

He offers this as one possible scenario for resolving the liquidity issues of European banks. (Bear in mind that I am leaving off the scare quotes when I talk about "liquidity" crisis.)

Here at home, does not the Fed balance sheet still include a lot of mortgage-backed securities? They were thought to be "illiquid" in 2008, but Bernanke and others thought that their "hold-to-maturity value" was well above their temporarily-depressed market value. I'm guessing that the market has not yet priced the securities to Bernanke's hold-to-maturity value.

Every week, it seems, a mainstream economist comes out with a new paper explaining how asset prices can be temporarily depressed in a liquidity crisis. (Recall that was the theme of the first three papers in the latest AER.) What I want to ask is whether the financial-panic story has a sell-by date. If central banks have to keep propping up a market for five years, is a theoretical model of temporary mis-pricing of assets due to asymmetric information and bad market dynamics still the best explanation?

I am assured that these papers are not simply rationalizations ex post for bailouts. They provide additional testable hypotheses and policy recommendations. Do any of them make predictions about how long the central bank must intervene before the liquidity crisis ends?

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COMMENTS (5 to date)
mark writes:

"Bernanke and others thought that their "hold-to-maturity value" was well above their temporarily-depressed market value". Is this true? I don't recall seeing reports of fundamental valuation analysis before. I thought they just wanted to prop up the banks and kept expanding the range of what they would buy until they succeeded. It's not as if the Fed has any financial reason to be careful in what it buys since it prints the satisfaction of its liabilities. Maybe there are political constraints but not financial ones.

More to the point, with Dodd Frank in place and the forthcoming bank capital requirements, the Fed has less ability to rescue a bank specifically so needs to be more proactive about liquefying the market generally.

Mike Rulle writes:

Yes, the argument made was the hold to maturity value was higher than the then market value.

Of course that would be true today as well, because the rest of the world would bid down the world's largest holder and seller. However, I did and still believe there was a liquidity crisis not a solvency crisis---of course at some point the line gets close. That is, the securities were valued at less than they will turn out to have been worth.

We should have let new buyers benefit then by buying securities cheap, or let negotiations work (like AIG and Goldman were doing before Blankfein and Paulson pulled their stunt for whatever motives)---not have the government purchase them. Or just force the banks to hold---as it is the securities they did hold were marked way back up by 2010.

But we have gone thru all of this before.

Now the sucker would be the Fed if they sold, because they would get "hosed". Yet we would be much better off if the Fed did sell or better, was forced to sell. We would unfreeze a good portion of the mortgage market and erase the past error. But Bernanke would have to take losses on his Hedge Fund.

Plus we would have to endure more "greed is evil"----imagine the politician who proposed that?

I guess by deduction Ron Paul already has.

Bob Knaus writes:

If you are the Fed, you can stay solvent longer than the markets can stay irrational.

(Not a falsifiable hypothesesis unfortunately.)

Garrett writes:
I am assured that these papers are not simply rationalizations ex post for bailouts.

How are you so sure?

mark writes:

The Fed can stay solvent infinitely. It's inherent in being able to print the money in which its liabilities are denominated.

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