Central banks have always drawn a line between illiquidity and insolvency. Illiquidity is often viewed as something temporary, an aberration where central bank intervention is permissible. Insolvency, on the other hand, is viewed as something fundamental and abominable and thus to be discouraged. Central bank intervention to restore liquidity to an illiquid market would simply bring prices back to fundamentals. Intervening to bail out insolvent firms would, however, encourage irresponsible behaviour and should be resisted. At least, so the catechism goes.
Central bankers know, though, that the line between illiquidity and insolvency is an extremely fuzzy one, made more so with developments in financial markets. Take, for instance, a mortgage loan made against a house. If the housing market is liquid, loans are easier to come by. The reason is obvious. One of the biggest costs to a lender is that if the borrower defaults, the house has to be repossessed and resold with substantial costs. If, however, houses are selling like hot cakes, then the cost of repossession and resale is likely to be small. Housing loans will appear low risk, the risk premium lenders will charge will be small and housing credit will be plentiful. In turn, this will increase the volume of house sales, increasing liquidity in housing markets. Liquidity thus tends to be self-fulfilling.
But this leads to a problem in assessing whether lenders have been irresponsible or not. A mortgage loan might be perfectly sensible and appropriately priced taking the continued liquidity of the housing market as given. And the same loan may be viewed as reckless, driving a mortgage lender into insolvency, if liquidity in the housing market dries up. Could the mortgage lender not legitimately run to the central bank for help, pleading that illiquidity rather than fundamental insolvency drove him over the brink? What level of liquidity is it appropriate to assure market participants of? And in what markets?
Such a question is not relevant only to housing credit. Expectations of future liquidity conditions are central to the price and availability of many financial transactions. A bank selling complex customised derivatives to clients should price them taking into account its own ability dynamically to trade and hedge its exposure in financial markets. If markets are likely to become illiquid, the bank should recognise that trading will be difficult in those times and incorporate that possibility into the price. Otherwise, too many derivatives will be sold, overwhelming the capacity of sellers to hedge them when markets turn illiquid and eventually creating worse financial market turmoil.
The point is that liquidity is not a free good; it has a price, much as any cash flow would.
An unanticipated shortfall in liquidity increases risks, as does a shortfall in cash flow, and both should have similar consequences. Over the past few years, financial firms have made enormous sums of money as the potential illiquidity they charged for up front in the contracts they wrote failed to materialise. Now that that illiquidity has finally materialised, should the government bail out those who out of greed, complacency or incompetence underpriced it?
These examples also highlight the central bank's dilemma in assuring markets of liquidity. Because of the self-fulfilling nature of liquidity, small interventions can sometimes revive moribund markets, seemingly at low cost. However, there are indeed costs, perhaps significant ones. First, by providing liquidity freely, the central bank alters the price of liquidity, thus rewarding the reckless and harming the cautious - much as a government-funded recapitalisation hurts the taxpayer. Second, if the central bank induces expectations of continued liquidity, market participants will adopt strategies that rely excessively on it. As such strategies build on each other they will eventually overwhelm the abilities of even the most deep-pocketed interventionist central bank. Thus, even from the perspective of moral hazard, the distinction between liquidity infusions and recapitalisations is fuzzy indeed.
So what should a central bank do in a time of market turmoil? It should clearly lend freely against unimpeachable securities and also maintain a liquid market in such securities. Anything more is problematic. To intervene by making a market in illiquid securities as some have suggested, or in illiquid assets such as housing, may be to imbue those securities or assets with a liquidity they never should have had and thus distort their value. And cutting rates dramatically, as Alan Greenspan's US Federal Reserve did after the technology bubble burst in 2000, would be an enormous tax on savers the world over. Better let the market weed out the reckless, unless there is a risk of total market collapse.
But knowing that the political pressure to intervene is asymmetric, asserted far more strongly when markets turn illiquid and asset prices fall than when markets are excessively liquid and asset prices booming, central banks ought also to avoid bringing such situations upon themselves. Better to "lean against the wind" with prudential norms, tightening them as liquidity exceeds historical levels, than to ignore the boom and be faced with the messy political reality of forcibly picking up the pieces after the bust.