Why do safe, liquid assets become so expensive in a financial crisis?

In my last post, I argued that the “liquidity” premium was one of the fundamental drivers of the recession. In exactly the same way that a small drop in the supply of cash can cause a massive spike in the nominal interest rate (quite possibly leading to a recession), small shifts in the supply and demand for liquidity can drive up the liquidity premium and push other interest rates to disastrously high levels—even when the Fed does its best with conventional monetary policy.

But why should the liquidity premium change so much, anyway? Brad DeLong is rightly skeptical:

Now we understand why demand for money–what I call liquidity–is so interest-inelastic. You need money to buy stuff. If you don’t have money, you can’t buy stuff–and so when you are short of money you cut back your spending because you must and so build your money balances back up.

But why is the demand for what Matt calls “liquidity” and I call “safety” so interest-inelastic in a financial crisis? It’s not that you have to cut back on your spending on currently-produced goods and services–you have plenty of cash money. But you are unwilling to part with some of your cash money because it is now–and here our terminological problem begins–part of your holdings of liquid cash money are now in the the delong-safe or the rognlie-liquid tranche of your portfolio that you feel you must retain at all costs.

But why must you retain it? Why not buy risky assets when there is blood in the streets? Why not become a stabilizing speculator and become a supplier of rather than a demander of delong-safe or rognlie-liquid assets?

First, to clear up my self-imposed terminological confusion, I’ve been using “liquidity” as a catch-all for many properties that distinguish base money: its complete lack of nominal risk, its short (indeed, zero) maturity, and its usefulness in transactions (which is what we’d often call “liquidity”). The key idea is that many assets resemble base money in all these respects, but aren’t quite the same—they can’t be carried around on green pieces of paper or used to satisfy the reserve requirements on checking accounts. I’ll call these assets cashlike.

What are cashlike assets? T-bills, commercial paper, and repo—plus the money market funds that invest in them. Traditional checking deposits, too—though perhaps only up to the cap on deposit insurance.

Why is the demand for cashlike assets so inelastic? To some extent, it’s for the same reasons that Brad argues the demand for cash money should be interest-inelastic: you need it to buy stuff, or more generally to conduct transactions. If the premium on cashlike assets rises, cutting back on the cashlike part of your portfolio might make it very difficult to go about business as usual—and that’s potentially much more costly than just coughing up the premium.

Now, this isn’t a fully satisfying answer. It’s not as if every dollar in a money market fund is absolutely necessary for some business to continue its operations. But the same is true for cash: when interest rates rise to 6%, paying all your bills with cash (or keeping a pile of $100s under the bed) should be much less attractive. You’d think there would be some demand response—a few holdouts finally deciding to pay with debit cards, or drug lords maneuvering their cash stockpiles into a bank account. And yet there’s virtually none: the naked eye cannot identify even dramatic shifts in monetary policy from the trajectory of currency over the last 40 years.

For some reason, portfolio substitution away from cash is incredibly, incredibly slow and weak. Why should we be surprised if the same is true for cashlike assets as well?

Inelastic demand, of course, isn’t sufficient to cause large swings in the premium on cashlike assets. We also need inelastic supply. And as Brad points out, it’s not clear why this should be true either:

We know why people don’t turn around and become suppliers of liquid cash money when the money stock contracts: they can’t, for nobody else’s liabilities are good as payment for transactions in currently-produced goods and services. But surely Berkshire Hathaway or Microsoft or Northrup-Grumman could have sold lots of bonds at attractive values. Why didn’t they?

According to the Federal Reserve Flow of Funds tables, at the end of 2008 there was $3.8 trillion in bonds issued by nonfinancial corporations, along with $132 billion in commercial paper. But only a small fraction of that $3.8 trillion was issued by corporations with credit sufficiently good that it could plausibly be transformed into a cashlike asset. (After all, the companies with really good credit ratings tend to be precisely the ones with low leverage.)

Even if every AAA corporation doubled its debt overnight, issuing all the new debt in the form of commercial paper, the supply of cashlike assets wouldn’t increase by anything close to $1 trillion—which is a lower bound on the decrease in supply associated with the financial crisis. (Flow of Funds table L.207 shows a nearly $1 trillion drop from 2007 to 2008 in repo + federal funds. Over the same period, table L.208 shows that there was a $200 billion decline in open market paper—which becomes a $900 billion decline if you compare the 2006 peak to the 2010 trough.)

But AAA corporations didn’t even do this; in fact, there was barely any response to the sudden availability of extremely cheap financing. Why? I’m not completely certain, but this isn’t much of a mystery next to all the other mysteries of corporate finance. If it’s hard to explain why Berkshire Hathaway didn’t immediately take advantage of, say, a 4% premium on cashlike debt, it’s infinitely harder to explain why a financially sound corporation doesn’t lever up when the tax advantages could add 15% to firm value in an instant.

Bottom line: corporations, at least in the short run, are unlikely to provide a very elastic supply response to a change in the premium on cashlike assets.

What other asset suppliers might step in? Again using Flow of Funds Table L.2, we can see the amount of various debt instruments owed by nonfinancial sectors in 2008:

  1. Mortgages: $14.4 trillion
  2. Treasuries: $6.3 trillion
  3. Corporate bonds: $3.8 trillion
  4. Municipal securities: $2.7 trillion
  5. Consumer credit: $2.6 trillion
  6. Bank loans not elsewhere classified: $1.8 trillion
  7. Other loans and advances: $1.8 trillion
  8. Commercial paper: $0.1 trillion

Aside from money created by the Fed, any additional supply of cashlike assets has to come from one of these categories—maybe it’ll be packaged by a financial intermediary, but ultimately it must rest on some claim on the nonfinancial sector. But which one? Treasuries, eventually—but in the meantime, what elastic source of supply is there?

Clearly the biggest category, mortgages, was useless in 2008: the whole point of the crisis was that previously riskless mortgage-backed securities suddenly became questionable. As the possibility of 10% unemployment loomed, consumer credit wasn’t looking good either. And it has never been very practical to turn other loans—loans to idiosyncratic borrowers, without standard collateral like a house or office building—into securitized assets that can be traded like cash. (That’s why we have traditional banks in the first place.)

Now, with enough time and energy, financial institutions could have stepped in and created new assets: you could take a diversified portfolio of Baa corporate bonds and mark off the top 50% as an AAA tranche. (Short of the Rapture, it’s hard to imagine the default losses on a large portfolio of Baa bonds being even 10%, much less 50%.) But this kind of financial alchemy isn’t instantaneous—it takes time and resources, both of which were in short supply during the crisis of 2008.

And there’s still the problem of maturity mismatch: even if banks manage to put together a new crop of nominally riskless long-maturity assets, transforming them into cashlike assets requires someone to borrow short and buy long. In the midst of the financial crisis, this was not easy to do; the banking system was largely incapacitated, with institutions either unwilling or unable to subject themselves to more rollover risk. Anyone using repo funding had to cough up the haircut, which was 6% even for long-term Treasuries in fall of 2008. (Not to mention 20% for A-/A3 or greater corporate bonds, 30% for many asset-backed securities, and 40% for “AAA” MBS, as documented by Table 4 in Arvind Krishnamurthy’s excellent piece.)

In short, there were very powerful forces keeping the supply of cashlike assets inelastic during the financial crisis.

Of course, this still feels unsatisfying. Shouldn’t someone have stepped in when the premium on cashlike assets was high enough to cause a deep recession—a recession that led to perhaps $20 trillion in financial losses? The magnitudes don’t match: why did a comparatively tiny shortfall in this one market lead to catastrophic outcomes in the broader economy?

As I pointed out in the last post, the answer is that there’s an externality, potentially a very large one. Once the federal funds rate hits the zero lower bound, the premium determined in the market for cashlike assets has a direct impact on the yield of every asset in the economy. It doesn’t matter how small the market for cashlike assets is compared to the economy as a whole: if the premium on T-bills increases by 2%, the cost of capital for everyone (at least everyone who can’t issue cashlike debt) will go up by 2%. In this setting, a bank deciding to issue more commercial paper internalizes only a tiny fraction of the social benefits from its decision: sure, it gets some cheap funding, but by bringing down the premium on cashlike assets it changes financing decisions across the board.

We typically think that banking crises are bad because banks play an important role in providing credit. No doubt this is true to an extent. But banks are also important because they are uniquely responsible for the creation of cashlike assets—assets that become fully substitutable for cash at the zero lower bound, and whose premium influences every interest rate in the economy. This is where the true power of a banking crisis kicks in: if the central bank doesn’t respond in the right way, all credit (even credit not provided by banks) becomes ruinously expensive.

That is what we faced in 2008—and what I hope we never face again.


Filed under macro

16 responses to “Why do safe, liquid assets become so expensive in a financial crisis?

  1. Great blog, Matt. Very intellectually stimulating and I have added it to my daily list.

    One question: I was a bit confused by why people would like for banks to issue commercial paper. Are bank liabilities particularly safe (esp. in 2008)? I thought banks were having trouble issuing at high prices and that might explain their relative non-issuance. Perhaps I am misunderstanding, though.

    • Thanks! I’m glad you like the blog.

      Bank liabilities are not necessarily safe, but even in the depths of the 2008 crisis, financial institutions were continuing to roll over a surprising amount of commercial paper. Apparently, market participants were still (mostly) willing to accept these short-term liabilities as essentially riskless. Banks were constrained and tried to cut back on their issuance, though, because all the short-maturity liabilities on their balance sheets put them in a more tenuous position.

      Here is one externality I’m thinking about: suppose that you were a bank in 2008 in relatively good financial shape. You could probably write more commercial paper if you wanted to (and, by investing it in non-cashlike assets, earn the yield spread), but the gain wouldn’t really be that large, and by increasing the short term liabilities that you needed to roll over, it would expose your bank to more risk in the future. You might conclude that the risks outweighed the benefits—but if you internalized the much larger macroeconomic benefits from increasing the supply of cashlike assets, the decision might go the other way.

      A more convincing externality deals with ex-ante decisions. By raising a lot of equity financing and having a lower-leverage balance sheet in normal times, a bank can put itself in a position to profit when things go haywire during a crisis and there’s lots of money to be made from creating cashlike assets. But since the bank only earns its private return from the yield spread, not the social return from alleviating the liquidity crunch in a crisis, the private benefits from this kind of precautionary behavior don’t match the social ones, and banks keep riskier balance sheets in normal times than they should.

  2. Matt Waters

    “If it’s hard to explain why Berkshire Hathaway didn’t immediately take advantage of, say, a 4% premium on cashlike debt, it’s infinitely harder to explain why a financially sound corporation doesn’t lever up when the tax advantages could add 15% to firm value in an instant.”

    There may have been some behavioral issues at the time which the elasticity models for interest rates do not really capture. Many companies, such as GE, were facing downgrades from ratings agencies trying to save face from AAA-rated CDO tranches. CFO’s may have been more worried about how a big debt offering may effect its debt rating or how it may look like the firm is desperate for cash.

    Another behavioral issue could be that there are a limited number of big players in the main financial centers, mainly banks and fund managers. They all hold some form of paper on behalf of others. Even if a hedge fund manager would be perfectly fine balance-sheet-wise holding a corporate bond, the hedge fund has to sell if their investors are liquidating. A shortfall in buyers creates an extremely inelastic market for any security, no matter how good it is.

    In normal times, this kind of behavior is not an issue. If investment decreases, the Fed can decrease interest rates to make safe investments less attractive. Even if the risk premium goes up, for whatever reason, the Fed can reduce safe interest rates to make up for the risk premium’s increase. With the same nominal rate as before (high risk premium but lower risk-free rate), the supply of risky investments should not change because those who take on risky debt (CFO’s of junk companies, riskier homeowners and credit card consumers) do not see a change in their nominal rate.

    However, if the risk premium balloons when the rate hits the zero point, nominal risky interest rates balloon as well. Junk company CFO’s are not going around issuing bonds with sky-high yields. Reflexivity takes hold, where the high risky interest rates themselves increase their underlying assets’ likelihood of default. Even without adding in risk premium, higher funding rates make the bonds fundamentally less valuable.

    This reflexivity creates the bifurcation in asset values DeLong pointed out in late-2008. Even though Japanese debt/GDP ratio is 150+%, they do not suffer from reflexivity because investors expect other investors to value Japanese bonds in a flight-to-safety. On the other hand, CDO tranches, junk bonds and even some higher grade commercial paper may not be part of that exclusive club. Reflexivity kills their paper’s value and stops the issuing of all new, risky paper.

    Meanwhile, Japan, the US and AAA companies such as Berkshire Hathaway are not going spend fast enough to make up for trillions of dollars in shortfall in risky investment due to the newfound extreme rates. A monetary authority has to act decisively and put more types of paper into the non-risky paper. When the Fed started accepting much more collateral, it effectively stopped the cycle of reflexivity for many types of assets and helped AD tremendously. The Fed still needs to lower expected real interest rates further, though, to hurt investors more who hold cash and do not find a place to invest it.

    It’s also important to note that spending (i.e. AD) is the main issue, not investment. If Berkshire Hathaway issues a billion dollars of bonds at their low interest rate, but then the cash just sits on the balance sheet, that will not increase AD. That money has to be actually spent on something that goes towards PQ. Otherwise, it’s useless.

  3. anon

    One thing I find unclear is why an increase in the liquidity premium causes the value of other assets (e.g. Baa bonds) to fall so sharply. Even though most market participants cannot issue safe short-term bonds, one would expect that they would rebalance their portfolios towards risky assets, and perhaps invest more to take advantage of the higher expected return. One can of course argue that the low valuations were justified (due to expected NGDP shortfall, default risk etc.), but this is not part of your basic story.

    • It sounds like you’re arguing that the demand for cashlike/liquid assets shouldn’t be so inelastic—instead, as the liquidity premium increases, people should start shifting to less liquid assets at a high rate. I agree that this a mystery, one that my post doesn’t really resolve, except by comparing it to another mystery (why cash holdings adjust so little in response to interest rate changes).

      My best hypothesis is that people hold cashlike assets to meet liquidity needs, needs that are critical enough that people aren’t swayed to change their portfolios in the short to medium run when the liquidity premium increases. Alternatively, maybe there is some level of “rational ignorance”, and many investors only choose to reevaluate their portfolios once in a while, so that demand is short-term inelastic even when it is elastic in the long term.

  4. axiom

    “the naked eye cannot identify even dramatic shifts in monetary policy from the trajectory of currency over the last 40 years”

    exactly right
    so why have monetarists spent 40 years trying to disprove the facts?

  5. David Pearson

    The “liquidity premium” argument is a useful one in explaining the 2008 crisis. The question is how useful it is to explain anything in 2011. Credit markets have experienced a robust recovery in the past few years. Corporate, junk, emerging markets and CRE credit spreads are at low levels, and issuance is literally booming. Meanwhile, one of the riskier stock market indexes (Russell 2000) recently touched all time highs. What explains “excess demand for safe assets” in an environment where capital markets are functioning smoothly and risk assets are rallying strongly?

    • Matt Waters

      The argument Scott Sumner and Matt Yglesias have made is that things in the credit markets are “normal.” Risk premiums on different classes of investments are at what you would expect for a healthy economy maintaining 5% unemployment, and the economy is maintaining the unemployment rate. The only issue is that the unemployment rate is staying steady at 9%, not 5%. You need yields below the “normal” rates for each class to encourage enough aggregate demand to have a sizable employment recovery. And at the zero bound for short-term bonds, the Fed cannot use its normal tools to lower yields for instruments with more risk.

  6. David Pearson

    I’m not sure “yields below normal rates” stimulate much aggregate demand. Combined with negative real Treasury yields, the corporate cost to borrow out five years has probably never been this low. As a result, bond issuance is booming everywhere but mortgages. The problem is little of the proceeds is flowing into new business investment. So there is plenty of demand for risk assets from investors; what corporations lack is confidence in investment projects. How would lowering the corporate WAAC another 50bp solve this problem?

    The other problem with QE has been that the portfolio balances effect is indiscriminate: funds released by QE flow seek higher returns in commodities/currencies just as they do in equities. Rising commodity (and import) prices hurt middle-class consumer confidence and hence AD; higher stock prices do little for corporate investment. Thus, reducing the cost of capital further could come at a cost to AD.

    • Matt Waters

      To show how yields effect investment, it’s better to look at an environment which is not at the zero bound. For example, the Fed Funds rate during the Tech boom peaked at 6.5% and later dropped substantially to 1% over a few years. Lowering short-term interest rates lowered all rates by 5.5% and many investments became feasible for companies which were otherwise not feasible with rates 5.5 percentage points higher. For example, for better or worse, low mortgage rates attracted many new homebuyers, which then fed into many new homes which would not have otherwise been built. Due to poor underwriting standards, many of these loans were of poor quality. Still, they show how Fed actions feed into the broader economy’s aggregate demand.

      With a zero rate environment, the dynamics change somewhat. Let’s say some company’s bonds have a constant 4% risk premium over the Fed Funds rate. In 2000, the bonds cost 10.5%. In 2003, the bonds go down to 5% and the company may issue more bonds because more projects are worthwhile. In 2008, the bonds go down from 7% to 4%.

      At 4%, the company has a “historically low” rate, but the pessimism is too great from the company’s management to do much real investment at that low rate. If all companies have the same pessimistic expectation, than lack of investment (and consumption) will take place across the board. If the Fed Funds rate stays at 0% and the Fed does nothing unorthodox, then that status quo of pessimism will remain.

      In a parallel universe, the Fed could drive interest rates negative by penalizing everybody holding cash. No, I’m not recommending it and it’s not even close to feasible. Hypothetically, though, if the Fed could charge everybody holding dollars -2% interest, the company’s rate becomes 2%. If that’s not enough to drive investment, then the Fed could charge -6% and the company’s rate becomes -2%. At a certain point, the company would issue bonds. And because it costs -6% to just hold cash, they would find real investments and demand would go up. At some point, the economy would get out of its funk.

      The Fed can’t actually do that though at the zero bound and the Fed has to take unorthodox action to encourage more demand. To create the equivalent of the penalty for holding money, the Fed can increase inflation expectations. By inflation expectations, I mean going from -1-0% to 2-3% TIPS spreads. The inflation rate at or below the average for the last 20 years is hardly catastrophic to savers.

      Higher inflation rates, though, DO encourage those holding cash to find suitable investments. The stock markets, and other markets, remarkably followed talk of QE2. Not QE2 itself, but Bernanke just talking about QE2, which set inflation expectations higher and brought cash from the sidelines into stocks and other securities. The worry now, though, is that Bernanke will cave under all the Hawkish pressure to not continue with QE. The markets have appropriately responded with a slowdown in economic growth, based on a lower expectation for inflation and thus a higher expectation for more cash in vaults.

      Finally, it’s misguided to blame QE for commodity price inflation. I know that argument always falls flat with inflation hawks, but it’s true nevertheless. Oil prices rose on concerns about effects on the oil supply from the Arab Spring and increasing worldwide demand. Other commodities have been variously effected by droughts or floods. Furthermore, commodity prices have increased in all currencies, not just the dollar.

      Meanwhile, wages in the US have shown near 0 inflation. High inflationary periods are marked by tight labor markets where workers can demand continually higher wages, which feed a wage-price spiral. That is just not happening and it’s nonsense to predict that hyperinflation around the corner when unemployment is at 9%.

      Sorry for the long posts, but I do hope I’ve helped somewhat.

  7. David Pearson

    Thanks for the reply. Commodities are an asset class like any other. Their prices are historically the most sensitive to the expected path of Fed easing as well as to negative real rates. Further, QE has the effect of increasing demand for commodities in fast-growing emerging markets with pegged exchange rates. Therefore, it would be a complete surprise if QE did not raise commodity prices beyond where they would otherwise have been. Whether or not real supply and demand factors also affected commodity prices is a separate question.

  8. David Pearson

    Also, I wonder: if nominal wages are expected to be flat (“no risk of wage-price spiral”), and if the Fed has little influence on commodity prices, then how will easing lead to higher inflation expectations? Something must be expected to go up in price as a result of Fed actions. Shelter? Medical care? If the output gap guarantees no wage inflation, then I don’t see why should TIPS inflation spreads rise in response to easing?

    In a perfect world, I suppose QE could cause perfectly-calibrated expectations of nominal wage gains of 2% in the presence of a large output gap. Why this should be so is less clear.

    • Matt Waters

      Well, a couple of things:

      1. It is not true that commodities, more than other prices, inflate more from Fed policy. For example, in the 70’s core CPI actually outpaced total CPI by a good bit. As much as oil prices rose, regular prices and wages rose even more.

      2. Oil prices have risen about 50% from a year ago. However, oil prices have risen even more in Euros since the Euro has become weaker against the dollar. This is despite the ECB having much tighter policy than the Fed. Even if the Fed deflates the dollar by, say, 2%, this is a very small part of oil’s rise by 50%. The price rise is dominated by real factors in the market, including emerging world demand and uncertainty of supply because of the Arab Spring.

      3. Oil also declined by over 50% after September 2008 and it declined about 10% in a single day a few weeks ago. While the astounding rises in speculative commodity markets get huge media attention, the equally spectacular falls in commodity markets do not get the same attention.

      4. The most visible prices, the prices for food and gas, have a very large commodity component in their input costs. Most of the cost of gasoline is composed of taxes and crude oil. Gas stations and grocery stores must change their prices quickly to make a marginal profit. Meanwhile, most other markets have input costs dominated by wages. Even airline tickets mostly go towards labor, not jet fuel. Since wages are very slow to respond, other prices do not fluctuate nearly as much as commodities.

      5. For your second reply, I didn’t mean to overemphasize the wage-price spiral. The mechanisms of a wage-price spiral are important. In the 70’s, relatively few firms dominated many markets, such as the Big Three and automobiles. The UAW had generous COLA’s written into their contracts, which would increase their wages instantly. And because the Big Three dominated the market, they could feed these wage increases quickly into the price of their cars without losing market share.

      The mechanisms for inflation under QE don’t act nearly as fast. In 9% unemployment, I expect that most employees do not have enough market power to demand wage increases. Some sectors, like health care, are fairly tight though and those participants can demand wage increase or find new jobs with higher wages. Inflation would work through those markets (and again, broadline targets are 2-3%, not even close to 10+% like inflation hawks fear).

      As inflation expectations moves more cash from the sidelines into investment or consumption, more economic markets become tight like health care and thus more labor markets become tight. When those markets become tight, wages will increase in those markets. And that’s the real benefit of small inflation expectations: they create tighter labor markets and thus lower unemployment.

  9. Scott Sumner

    It’s been a long time since I did research on the demand for cash, but I seem to recall that most studies showed that currency demand did have some interest elasticity. The elasticity was fairly low (say 0.3 or 0.5), but certainly not zero. Is my memory wrong?

    Of course most currency is held for purposes of secrecy, and it is very costly to quickly adjust currency holdings via consumption. So the response is rather slow, and I suppose the short run elasticity is near zero.

    If currency demand really is that stable, what would happen if the Fed suddenly doubled the currency stock held by the public, via a negative 3% interest penalty on excess reserves?

    • Laurence Ball found a long-run semi-elasticity of 0.05 of demand for M1 with respect to interest rates: http://www.nber.org/papers/w6597.pdf. Not quite the same as demand for currency, but Ball observes that this number is a lot lower than it was in the prewar period.

      Of course, this is a long-run elasticity—to me, the plot of log currency that I linked above is pretty compelling proof that the short and medium-run elasticity is incredibly low. (At its peak, the Fed Funds rate reached 19%, and was >10% for several years… and yet the change in currency levels is not even really perceptible from looking at the chart.)

      The fact that currency is held for the purposes of secrecy might be an explanation for the low elasticity—but then again, not all currency is held for the purposes of secrecy (though a lot is), and even a drug dealer hoarding cash to avoid the authorities can figure out some way to launder the money if it becomes costly enough. The fact that, even so, we see basically zero response in currency demand is very interesting to me, and my guess is that it’s partly attributable to some kind of rational ignorance on the part of currency holders—they take a really long time to reevaluate the costs and benefits of holding cash, since the implicit costs from reoptimizing again and again are actually higher than the losses from carrying cash even when the yield spread is high. This definitely seems true for consumers—even someone using a lot of cash doesn’t track the movement of interest rates too carefully.

      The effects of a 3% penalty rate on reserves seem hard to predict, but my guess is that banks would find some way to strongly encourage their customers to withdraw some cash (and relieve them of reserves)… in the meantime, we’d see a weird situation as banks tried to get rid of the reserves by manipulating their payments on Fedwire (which, of course, wouldn’t do anything in the aggregate). The market would readjust more quickly here than in the opposite situation (where IOR and the FFR were raised to 3%) because banks would be the ones losing, and banks reoptimize a lot more quickly than consumers or random drug lords carrying cash.

  10. Matt,

    You appear to be groping your way from the conventional banking-regulator-academic perspective toward a more general understanding of the maturity-transformation crisis.

    Briefly, maturity transformation (borrowing short and lending long) is not a free-market activity. It can exist only in the presence of (a) fraud or (b) formal or informal deposit insurance by a monetary issuer. By creating spurious demand for future money, MT artificially depresses interest rates. Rollover is not a natural or healthy operation.

    What happened in 2008 was that the informal deposit-insurance structure of the shadow banking system broke down. Issuers of short-term money-market instruments, for instance, were practicing MT all over the place. GE’s 90-day notes were not backed by 90-day cashflow, but by investments of much longer duration – which could in no way provide 90-day return. Perhaps these were good investments, perhaps bad, but they were not 90-day investments. Reality is a harsh teacher.

    When Lehman failed, it became clear that this market was unprotected. The response of TPTB: no financial institution can fail ever. It would make much more sense to simply consolidate the entire banking system, foreign and domestic, onto USG’s balance sheet, as USG has effectively guaranteed its liabilities – which thereby become very genuine “dollars.”

    As you note, you’re using the term “liquidity” in the imprecise sense favored by the establishment. My house is illiquid, because buying and selling it incurs significant transaction costs. My 30-year T-bills can be bought and sold at near zero transaction cost, but they are highly immature. This is an extremely dangerous misuse of the English language.

    “Dollars” are simply equity instruments in the giant sovereign corporation we know and love as USG. When USG provides “deposit insurance,” it is simply lending dollars. Obviously it can issue its own equity ad libitum.

    My bank can safely back my zero-term “deposits” (ie, loans) with 30-year mortgage obligations, because USG via FDIC provides it with a free option to buy the mortgage obligations so as to make my deposit whole. This is a virtual stealth loan. Without it, interest rates would be much higher – to sell 30-year dollars for present dollars (borrow), you would need to find someone willing to sell present dollars for 30-year dollars (lend).

    Similarly, GE finances a project with 5-year return using 90-day commercial paper. USG, by informally insuring the money market, is effectively providing 4 years and 9 months of this loan. Perhaps your broker transforms the rest, and you get to treat the GE paper as cash. Which it isn’t. A financial system has a hard enough job as it is – we shouldn’t expect it to lie for us.

    Present and future money are qualitatively different – like euros and dollars. Without the assistance of USG, it is impossible to create an instrument of identical value to a dollar. You can collateralize a synthetic dollar with future dollars, with euros, with bottles of fine Bordeaux, but your synthetic dollar will never be worth 1.0 real dollars, as you can never exclude the possibility that when everyone liquidates the collateral will be sufficient. Perhaps the price of Bordeaux has simply been inflated by all the Bordeaux which was purchased to back everyone’s ATM deposits. Asset transformation on a systemic scale is a very dangerous game.

    A good thought-experiment in MT is to imagine that scientists discover an asteroid that will wipe out the earth in 2021. Without MT, what is the price of a zero-coupon bond maturing in 2022? Zero, as no one has any rational reason to exchange 2011 dollars for 2022 dollars. With MT, nothing prevents this phony asset from being transformed into apparent cash.

    However, it is impossible to simply turn off this bad practice, as it leaves us with a blatantly unpayable debt structure. Even without the asteroid, interest rates would be enormous. Systematic restructuring and repricing is the only alternative to “extend and pretend.”

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