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The discipline of economics has chosen its voices on the subject of liquidity: this week the field’s Nobel Prize was awarded jointly to former Fed chair Ben Bernanke and professors Douglas Diamond and Philip Dybvig, for work on banks and financial crises.
This entire newsletter, and frankly everything that I think about economics, begin from the failures, limitations and omissions of the viewpoints represented by this year’s winners. To be fair, one does not expect otherwise from the economics Nobel committee. Still, our actual collective understanding of the global financial system is impoverished, a loss that will be acutely felt, if not necessarily recognized, at the next financial crisis.
My teacher and co-author Perry Mehrling has recently wrapped up work on his new book Money and Empire, and so has his Kindleberger bibliography very close at hand. Following the Nobel announcement, Perry shared Kindleberger’s comments on Bernanke’s Nobel work, and with a few contextual annotations lets Kindleberger articulate the critique. CPK’s harshest line, by my reading: “For a Chicagoan, you [Bernanke] are courageous to depart from the assumption of complete markets.”
I’ll let Mehrling and Kindleberger speak for me on this, with one note.
Minsky never quite grasped market-making
Economist Hyman Minsky articulated a compact and broadly applicable theory of financial instability, distinct from Bernanke and Diamond–Dybvig: people stretch their cash reserves to take advantage of a boom, Minsky said; the system becomes fragile, so that when the boom ends, not everyone will be able to repay their debts. Charles Kindleberger had a concordant, but generally more comprehensive theory. The two found the overlap and worked together; Kindleberger even took the time to articulate Minsky’s limitations, as Perry notes. To my knowledge, Minsky did not reciprocate, at least not in his published writing. Late in his career, Minsky did try to come to terms with international financial and capital flows, perhaps trying to follow Kindleberger’s lead.
These efforts were not successful. To my view, the key insight that Kindleberger had, which Minsky never quite perceived, was that liquidity comes from market-making. Simply put, this is about the relationship between balance-sheet quantities and market prices. To take an important example, a central bank can control an exchange rate (which is a price) if it is willing to provide liquidity by allowing the quantity of its FX reserves to fluctuate. It can, in fact, control the price just as much as its balance sheet can fluctuate, and no more. Later generations benefit from Treynor’s helpful picture, but Kindleberger already knew how to think about the problem from having worked to understand earlier versions of the international monetary order. Minsky could have seen this, but didn’t.
This time will be the same
I mention this because Treynor’s and Kindleberger’s way of thinking about liquidity is practical and enlightening. For example, it is the bridge needed to get from Minsky’s own writings to the 2008 crisis. The mortgage crisis was very Minskyian indeed, but that only makes sense to those who know how to see the connection between frozen securities markets and frozen lending markets.
Neither Bernanke nor Diamond and Dybvig have anything like this sense of liquidity. For Bernanke, liquidity is an inherent property of certain financial instruments, assets that are or are not liquid, rather than a set of conditions that arise from the intentional behavior of market-makers. And for Diamond and Dybvig, illiquidity comes from the materiality of real assets—machines and buildings. These are not practical or enlightening contributions.
Luckily for all of us, the world seems set to provide a fresh round of datapoints on the resilience and fragility of liquidity in the international monetary system. Surely it will be a wake-up call for economics!
The liquidity Nobel
Re your answer. In 'open markets', i.e markets without capital controls, the exchange rate is defended via the capital market, mostly bonds, vide recent Bank of England intervention to jazz up the pound, which consisted of continued government bond-buying. Because the attack on the pound went through the selling-off of British bonds. But also, nowadays, small unwanted variations can be handled via the repo market, I suppose, or swaps. It it true, though, that the Danish central bank in 2021 defended the krone from appreciation by first buying foreign currency, then lowering the interest rate, but it would have had much more difficulty the other way around, running into a balance-sheet constraint, as you put it, or not having enough foreign currency reserves. But then the krone lives in relative protection by shadowing the euro and following the ECB interest rates, sometimes adjusting the margins a bit so as to be close to the central rate.
Thanks for the definition of liquidity, as 'a set of conditions that arise from the intentional behavior of market-makers'. However, I disagree with you when you say that central banks can control exchange rates (I mean if this is a statement that you endorse yourself, it is not quite clear), "a central bank can control an exchange rate (which is a price) if it is willing to provide liquidity by allowing the quantity of its FX reserves to fluctuate". Do you really believe that? To me, this is much too mechanical and also overlooks markets (say eurodollar for the US). Numerous are the central banks which have tried to flood the markets with their own currency or sell off foreign currency without the desired results. In olden days this was called intervention. In addition, there are differences between countries and, thirdly, normally central banks act through interest rates to turn the tide.