Liquidity and Solvency

During the financial crisis of 2008, some argued that the problem was bank solvency rather than bank liquidity. Why is that important? The conventional approach to central banking is to serve as "lender of last resort." According to that theory, the central bank should lend to illiquid banks. Those banks that are solvent, but illiquid, should obtain the liquidity they need by borrowing from the central bank.

On the other hand, this traditional dictum requires that the central bank not lend to an insolvent bank. An insolvent bank needs to be liquidated or reorganized. If letting an insolvent bank fail would have catastrophic consequences, then perhaps it should be bailed out. (An approach I oppose.) However, bailing out banks is not the role of a central bank as lender of last resort.

The banking system was (and is) heavily invested in real estate, including residential mortgages, commercial mortgages, and various types of mortgage backed securities. Housing prices have fallen 30 percent over the last three years. Many loans are "underwater." That is, the collateral for the loan is worth less than the outstanding balance. Worse, many of the home mortgages were made to speculators, hoping to profit from future price increases. Still worse, some of the loans were made to people who couldn't afford to make the payments, so could only avoid default by refinancing, which would only be possible if their home equity increased due to higher prices. Basically, the banks lent into a speculative bubble, and it popped. This is not a liquidity problem for the banks. It is a solvency problem.

If the sole role of a central bank is to help banks with liquidity problems, then expanded lending during the financial crisis would seem to be an error. However, today's central banks do not simply serve as "lenders of last resort." Helping banks with a liquidity problem isn't their most important role. Central banks serve as monetary authorities. They monopolize the issue of hand-to-hand currency. And since the transactions accounts that form the bulk of the medium of exchange are all redeemable in terms of hand-to-hand currency, they play a dominant role in the determination of the quantity of money.

The key role of a monetary authority is to prevent monetary disequilibrium--an imbalance between the quantity of money and the demand to hold money. If the demand to hold money increases, the most important duty of a central bank is to increase the quantity of money to match that demand.

This primary duty of the monetary authority has no direct relationship with the financial conditions of any bank. Is some bank illiquid or insolvent? Are many banks illiquid or insolvent? Are all banks illiquid or insolvent? These questions are secondary. If the demand to hold money is greater than the existing quantity of money, the central bank needs to increase the quantity of money even if the banks are not illiquid. If the demand to hold money is greater than the existing quantity of money, the central bank needs to increase the quantity of money even if the banks are insolvent.

During the financial crisis of 2008, most measures of the quantity of money increased. Evidently, the demand to hold money rose by even more. We know that because nominal expenditures fell during the fourth quarter of 2008 and then again in the first quarter of 2009. As measured by final sales of domestic product, nominal expenditures are only now approaching the level of the third quarter of 2008. They remain more than 10 percent below the growth path for the Great Moderation. The vast expansion in the quantity of reserve balances at the Fed, the huge increase in the quantity of the monetary base, and the modest increases in M1, M2, and MZM were evidently not enough. The Fed failed to do its duty as monetary authority.

To confuse matters, it is not at all unusual to refer to an increase in the demand for money as an increase in the demand for liquidity. People want to "get liquid." And while this often refers to a much broader set of assets than anything that serves as media of exchange--U.S. Treasury bills, in particular--holding hand-to-hand currency in a vault or FDIC insured transactions accounts are included. From the point of view of banks, funds held on deposit with the central bank also count as being "liquid."

I believe that Greece has a solvency problem, not a liquidity problem. Those banks that have lent money to Greece, therefore, have a solvency problem as well. However, it is likely that worries about the solvency of banks will create an increase in the demand to hold money. The role of the ECB, as monetary authority, should be to accommodate that increase in money demand. Further, it is entirely likely that along with, or instead of, an increase in the demand for euros, there will be an increase in the demand for dollars. The Fed's primary responsibility of monetary authority is to increase the quantity of dollars enough to accommodate the increase in the demand to hold dollars.

If central banks, particularly the European Central bank, but also the Federal Reserve, fulfill their core responsibilities as monetary authorities, the bankruptcy of the Greek welfare state can be weathered without another Great Recession.