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:
- Mortgages: $14.4 trillion
- Treasuries: $6.3 trillion
- Corporate bonds: $3.8 trillion
- Municipal securities: $2.7 trillion
- Consumer credit: $2.6 trillion
- Bank loans not elsewhere classified: $1.8 trillion
- Other loans and advances: $1.8 trillion
- 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.