Here’s a thought experiment: what would happen if gas stations suddenly started requiring payment in cash? Would there be a recession?
Of course not. It wouldn’t be a big deal: you’d probably carry around a little extra cash for when you needed to buy gas, but your life would stay mostly the same. It’s hard to imagine that the hassle would cause you to change your driving habits, much less your other consumption—even at high interest rates, the forgone interest from carrying a few hundred dollars in cash to prepare for fill-ups is minimal next to the cost of the gas itself.
So why am I mentioning a recession? How could such a trivial issue possibly have any serious macroeconomic consequences?
It wouldn’t—but understanding why is more subtle than you think.
Imagine a world where the Fed, rather than targeting interest rates, changes the size of the monetary base (the sum of cash and bank reserves) according to some rigid rule. Perhaps it increases the base at a rate of 5% a year. In this world, the sudden imposition of a requirement that motorists pay cash would cause an increase in the demand for base money—but no corresponding increase in supply. Since the short-term demand for base money is incredibly inelastic with respect to the nominal interest rate (minimal fluctuations in the supply of base money are enough to implement massive changes in the federal funds target), even a modest increase in the demand for cash would be enough to produce a large, contractionary spike in the federal funds rate. And thus a seemingly irrelevant change in the method of payment for a tiny part of the economy would be enough to send the United States into a deep recession.
Of course, central banks around the world realized long ago that this would be a problem—that’s why they target interest rates, not the total supply of base money. But there’s still a lesson here: somehow, a small change in the demand for one asset (cash) has the potential to bring a $15 trillion economy to its knees, if the Fed doesn’t respond in the right way.
Anyone trying to understand the crisis of 2007-2008 should be paying close attention. The central mystery of the crisis (and, indeed, many other crises) is how a relatively minor initial loss—$500 billion to $2 trillion, of the same order of magnitude as the change in the value of equities during a weak month—somehow led to a much larger collapse in the economy as a whole. As Brad DeLong puzzled in late 2008:
And our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level but that has led to ten times the total losses in financial wealth of the impulse.
Now imagine that we have a shock to demand for liquidity in general rather than cash. For whatever reason, investors want to park more of their portfolio in T-bills and repos, and less in illiquid bonds and equities. At the same time, imagine that the supply of liquidity is actually decreasing—the “AAA” tranches of mortgage-backed securities are no longer acceptable collateral, and in general it’s much harder to transform real, risky assets into liquid, riskless ones.
What happens? Remember that with a shock to cash demand, nothing happened as long as the Fed targeted the federal funds rate: it would supply whatever additional cash was necessary to keep the interest rate at its target level. But with shocks to liquidity supply and demand, the world isn’t so rosy. At least traditionally, the Fed doesn’t target the liquidity premium. (Though QE/QE2 may be viewed as attempts to do just that.) Classic “open-market operations” are just trades of base money for T-bills—one liquid asset for another—leaving supply unchanged. As a result, if short-term supply and demand for liquid assets are inelastic, even a small shock can produce a large spike in the liquidity premium, and a rise in interest rates in general. In exactly the same way that a few gas station owners demanding cash could raise the price of credit across the economy, a small decline in supply or increase in demand for liquidity can force up the interest rates paid by all businesses and consumers, leading to a severe contraction.
Now, if the Fed realizes what’s happening, it can offset the effect of an increase in the liquidity premium by decreasing the federal funds rate. But this standard reaction may be delayed, and eventually it becomes impotent: the federal funds rate hits zero, and exchanging money for T-bills can do no more.
At this point, the fate of all assets in the economy is determined by the idiosyncrasies of the market for liquidity—which, like the market for cash, may be very small relative to the economy as a whole. A few pension funds deciding to move $100 billion (<1% of GDP) from real estate into liquid assets can—by increasing demand in an inelastic market—cause a noticeable runup in all interest rates, interest rates that govern almost $50 trillion in household financial assets. On the supply side, we’ll see the same effect from a change in market expectations that renders useless $1 trillion in repo collateral.
So we have a way that small losses in one market can lead to far vaster consequences: they cause a disproportionate change in the liquidity premium, which (once the Fed has dropped rates to zero) is responsible for determining every single interest rate in the economy.
How is this possible? Why should the whims of a few players in the market for liquidity make such a difference to macroeconomic outcomes? Doesn’t this mean there’s some kind of externality?
Indeed there is. Remember that money is the unit of account. It’s not hard to imagine why there is an externality in a world where all prices are denominated in, say, Mountain Dew. By changing the supply of the standard by which all goods and services are priced, your decision to pop open a can will have economic consequences far more profound than your momentary buzz. Similarly, in a world where the Fed fails to adjust the monetary base, gas stations’ decision to require cash affects economic outcomes in a way that belies their small role in the economy. And once the economy has reached the zero lower bound—and money is just another liquid asset—minor shocks to the supply and demand of liquid assets can have catastrophic consequences.
We saw this in 2008. Even as the Fed eventually brought the federal funds rate down to zero, the rates that actually mattered in the economy shot upward.
What does this all mean?
For one, it suggests that the quasi-monetarists were right. As David Beckworth argues, there was a great liquidity shock in 2007-2009 that made monetary policy effectively very tight. This doesn’t mean that monetary policy can fix every problem—not all zero lower bound episodes are caused by a liquidity shock, and in those cases zero is a very real barrier. But when a shortage of liquid assets is the main issue, the Fed has a simple remedy: trade money for illiquid assets. If it does enough, it’ll bring the liquidity premium down to earth, and allow the interest rates faced by businesses and consumers to decline to levels consistent with economic stability.
It’s unintuitive to think that such a severe recession was provoked by shocks to a single market, shocks whose total dollar value was trifling in comparison to the subsequent downturn. But after a little reflection, there’s a natural connection to monetary economics. We already know how a quantitatively trivial shock can devastate an economy: the formidable Volcker tightening, which led to the highest unemployment rate since the Great Depression, was just a small blip in the monetary base. We understand all this with the market for money. Yet somehow we haven’t managed to make the connection to the market for liquidity.
Someday we will.