Economist Bengt Holmstrom has spent years studying how the behavior of firms interacts with larger economic currents. Now Holmstrom, the Paul A. Samuelson Professor of Economics at MIT, has a new book out analyzing the supply and demand of easily transferrable (or "liquid") assets for corporations, and the resulting implications this has for policy-makers. The work, Inside and Outside Liquidity (MIT Press), was co-authored with Jean Tirole, an economist at the Toulouse School of Economics in France.
Q. We just went through a global banking crisis, in late 2008, where lending appeared to freeze up. What are the lessons we can learn by studying liquidity in its aftermath?
A. One lesson from the crisis is that we don't understand the role of liquidity, the nature of systemic risk, and the efficient provision of insurance nearly as well as we thought we did. It is essential that we use this disastrous event to improve our understanding of the basic functions of liquidity — that is, financial claims like deposits or currency or credit lines that are perceived to be extremely safe. In the book, we ask why people and firms demand liquidity and what determines the economy's ability to meet this demand.
Many people have implicated financial engineering and the complex products it created in the crisis. But the idea of securitization [turning certain types of debt into bonds] makes eminent theoretical sense and quite likely was a response to the huge global demand for safe places to park money. In the end, the system wasn't as safe as assumed. The amount of liquidity in the economy is largely determined by the beliefs people hold about the safety of financial claims. As we saw, beliefs can change very rapidly and liquidity can collapse spectacularly. We need a better understanding of this sudden transition, what can be done to avert it, and how a crisis should be managed once it gets going. Central to all this is a deeper understanding of liquidity itself.
Q. Should government help manage the flow of liquidity in an economy?
A. The government has to intervene once a crisis gets going. When faith in the supply of normally liquid claims turns into doubt, Treasury bills and bonds are where people go for safety. Thanks to massive Federal Reserve intervention, we avoided a complete meltdown. Government intervention to stop a crisis will necessarily require taxpayer money. In our book we show why sharing the risks in this manner can be an efficient insurance plan for the economy before a crisis occurs.
There is more disagreement on how safe we should try to make the financial system. The paradox is that by reducing the risk of a crisis, or rather the perception of that risk, the consequences of a crisis can get significantly magnified. Had people worried more about the safety of the system, less liquidity would have been created. I think we need to make creditors bear more risk, but how much is far from obvious.
Q. How much transparency in banking, and in business generally, is enough?
A. Most people think that a lack of transparency was a contributing factor in the financial crisis and that the opaque designs of bonds and other financial instruments may have been intended to mislead. In fact, liquid instruments are ones where you don't need to inquire about credibility or question the intent of the partners you trade with. It's about trust, not in the sense that one trusts individuals, but rather that one trusts that there is enough collateral to back up promises. Money — a twenty-dollar bill, for instance — is the world's most opaque product. This is exactly why it is liquid. It is certain that neither side has any private information about the bill (taking out counterfeit currency from the argument). So equal ignorance is a pretty good state for liquidity-providing markets.
This is why debt is the preferred instrument to provide liquidity. Its value is totally insensitive to specific knowledge about the underlying collateral as long as there's enough of it. Unfortunately, there are rare times when the collateral, such as housing, drops in value so much that debt becomes information-sensitive. That's when a crisis may ensue. So lack of transparency in no way implies that there must have been greed or corruption. But society may want more transparency than private markets naturally provide. In particular, society may want to certify that there's enough collateral at all times. My sense is that intermittent stress tests of banks would be a reasonable thing. I also think increasing equity in banks is good, but how much is very difficult to tell. And then the shadow banking system has to cast its shadow aside; it is highly non-transparent, so developing some kind of clearinghouses to make it more market-like seems plausible.