Should We Penalize Liquidity Preference?
By Arnold Kling
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.