The Money View

What a liquidity crisis looks like

Bloomberg's reporters continue their diligent work looking back on the Fed's lending in the subprime crisis. Matt YglesiasYves SmithPaul Krugman, and others have picked up the story. Meanwhile, the world looks ahead to the next development in the eurozone crisis. To read these crises correctly, liquidity should be front and center. It is missing in Bloomberg's work, and it is missing in European policymaking.

A bank, or any firm, or indeed any economic entity, must constantly evade the survival constraint (a term from Minsky). When it can't pay its bills, its creditors can resort to the legal system and shut it down. This is the moment of illiquidity—the inability to come up with the cash to meet obligations.

The payment system has facilities for ensuring that the failure of payment by one party does not lead to the failure of payments by other parties. The private money market allows firms to postpone this day of reckoning, at a price. The central bank, at the center of the payment system (in the US as in Europe), ensures the availability of bank reserves so that one day's postponement can be obtained at its target price. In an everyday, non-systemic liquidity crisis, a single payment fails, and the system flexes just enough so that this failure does not spread. Little crises like this happen all the time, and usually the system contains them.

A liquidity crisis becomes systemic when many payments fail, enough that large parts of the system are squeezed up against the survival constraint. Mortgage defaults come in higher than expected, so payments to holders of mortgage-backed securities come in lower than expected, so guarantor banks have to come up with cash quickly.

In both cases, solvency is a concern at some level. But what finally gets the lights shut off is that the electric bill doesn't get paid—illiquidity, that is, whether or not the household, or bank, or country is solvent. Our understanding of the central bank's role as lender of last resort is that, when the risk is that a large part of the financial system will go dark, so to speak, it is better to bite the bullet, provide liquidity, and keep the lights on. This is from Bagehot, of course, but also Minsky, Kindleberger, and Hawtrey.

What is missing from Bloomberg's extensive report is an understanding of the liquidity dimension of the crisis of 2008. Bloomberg argues, for example, that banks earned $13B of profit on these loans, a figure based on net interest margin, the difference between the interest earned on a bank's assets and the interest paid on its liabilities, a claim that has been uncritically accepted by many in the blogosphere.

The figure assumes that the funds were just routine deposits, that were turned around and lent out to routine borrowers. But this view makes the entire crisis look like one of solvency, when it was evidently one of liquidity—Bear and Lehman were gone, AIG was on life support, and no one would extend credit beyond overnight for fear that the money would not come back. What if the Fed's lending had not been there? Deleveraging would have been the likely result—asset sales into a falling market to raise cash. Below-market interest rates may not have been too high a price to pay to induce banks not to contract their balance sheets at the height of a crash.

As I have argued before, the Fed made far graver failures than can be seen in Bloomberg's documents. The Fed failed to adapt to a changing financial system, it failed to protect the payment system from excessive risk-taking, and it failed to react quickly enough as the crisis erupted. The liquidity shortage was of a different kind than the Fed was prepared to meet.

Today in Europe, policymakers dwell on austerity measures and the idea of a fiscal union, assuming that if these solvency concerns are resolved, the liquidity problems will solve themselves. But illiquidity is what will take down major European financial institutions first, solvent or not. Before too much longer, let us fully absorb the liquidity lessons of the last crisis.



To say that the financial crisis is a liquidity crisis completely misses the point.

The heart stops pumping and the blood stops flowing when the brain dies.

AIG and the rest were in every sense brain dead - theirs was a fundamental solvency problem which led to the liquidity problem. Sure, they could have been kept on life support and they would then be just like all the other banks whose solvency is dependent upon what is now a fundamentally insolvent and/or illiquid population where >90% of people are in debt to the <10%.

But to do so would not have solved the underlying problem which requires systemic fiscal reform to resolve it - and by this I do not mean the sort of Austerian remedies which are the equivalent of applying leeches or removing the limbs from the patient.

Your view of money - and of individuals as banks - is fundamentally misconceived, being bank-centric.

The fact is that banks are simply intermediaries - their economic purpose is to guarantee the performance of credit transactions between individuals (trade credit), and between individuals and the owners of productive assets.

The basis of credit is not the bank, it is the capacity of the individual to provide goods and services and the use value of the productive asset respectively.

You would be well advised to extend your study of money and credit to the period before the Bank of England first privatised public credit in 1693, and to examine the role of 'Stock' and the tally sticks which gave us that word (and also the financial meaning of the word 'return') and formed the basis of UK sovereign financing and funding for hundreds of years.

A Stock Answer

It is this bank-centric view of money which completely invalidates any economics based upon it, and virtually no schools of economics are exempt from this error which more or less invalidates any forecasts built upon it.

Garbage In = Garbage out.

But note here that even if the Treasury-centric view of the chartalists/MMT'ers is correct in terms of the creditary nature of modern fiat money, it does not mean that it is any more desirable or necessary for the Treasury to be a credit intermediary than it is for a bank (public or private).

MMT'ers - like you - would need to develop a Modern Fiscal Theory in order to form the basis of a coherent economics.

The future in my view - which is already here in prototype - is for direct 'peer to peer' credit (NOT debt) and 'peer to asset' investment.

But that is a different - 21st century - story.


As you well know, the advice to central banks that Walter Bagehot gave was, in a financial crisis, to "lend freely, but at a penalty rate". The question is not why the Fed lent freely. The question is why they did not do it at a penalty rate. Do you have an explanation as to why it was necessary for them to lend freely at "below-market interest rates"?


Hear, hear! Beautifully stated. Why the central bankers continue to stick their heads in the sand on this is beyond me. There can be only one explanation, since it's an intellectually bankrupt, they are merely hoping to retain an ill-gotten reputation. In short, they are protecting their egos, putting at risk the entire economic edifice that they nominally serve. Shameful. That Mr. Greenspan is still allowed to weigh in on this issue is at best puzzling, but indicative that "good ol' boy" networks exist at all levels of society..


Chris, we are in fundamental disagreement. Banks do not "simply" intermediate between savers and borrowers. The liabilities of banks, which is to say deposits held at them, are money, in that they can be used to make payment. The liabilities of other borrowers are not, for the most part.

Let me also state emphatically, for the record, that I am not an MMTer. While MMT gets some of the story, for example the mechanics of government spending and taxation, they consolidate the Treasury and the Fed into a single government balance sheet. I do not agree that this consolidation reflects the institutional reality.


I need to reserach for 3 banks that had liquidity crises in the past 3 years. not as part of the systamatic risk but as part of assett liability management.
Can anyone help please?

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