The financial markets are in crisis mode once again. The flight-to-quality is in full effect with safe haven assets in high demand; gold is breaking new highs every day while US and UK government bonds are falling to record lows.
The move is like a bank run, with investors pulling money out of investments in banks and risky assets as fears of an escalating Euro Zone crisis adds to the global uncertainty surrounding the future path of prosperity.
Diamond and Dybvig (1983) published an important paper on bank runs and liquidity with the key concluding points being that governments must act to remove the asymmetric information in the minds of depositors by providing deposit insurance. Similarly, Caballero and Krishnamurthy (2008) introduced the idea of Knightian uncertainty to this model, where uncertainty can be explained in the words of the former US Defence Secretary Donald Rumsfeld as unknown unknowns as opposed to risk which are measurable known unknowns.
Again, the second paper shows the importance of government intervention to calm the fears of the market in times of crisis. The markets must have confidence in the ability of policymakers to act decisively to reduce the uncertainty in the markets, only then will the market panic subside for a sustained period.
Caballero has been highly critical of the actions by the US Treasury especially when it decided to allow Lehman Brothers to collapse. If the crisis is analysed, it was not until leaders such as Gordon Brown stepped into support the UK banks that financial markets eased back from the brink. Furthermore, liquidity in the short-term interest rate markets only returned when the UK and US introduced QE and the ECB added 12-month Long Term Refinancing Operations (LTROs). The 12-month LTROs, in particular, were instrumental in bringing liquidity back to the markets and this shows that if policymakers take uncertainty out of the equation then market panic eases back. In the case of the LTROs, the provision of unlimited cash for a long-term period at a guaranteed 1% rate received overwhelming demand in June 2009 and this meant all European banks were awash with cash with which to finance their balance sheets. This was a very public signal that banks’ liquidity needs would be fully supported by the central bank.
The current problem is not just about illiquidity in the financing markets but more to do with uncertainty surrounding the future of the Euro Zone and US economies. Euro Zone politicians have been fluffing their lines for at least the last 18 months while the US debt ceiling brinkmanship only eroded confidence in US leaders.
Politicians are faced with tough decisions which may prove unpopular with large sections of their electorates in the short term but if Euro Zone leaders want to save the monetary union then they have to show the market that they are fully behind the project by introducing a level of government backed insurance for the weaker members of the Euro Zone. This can only be a fiscal union and the issuance of a European government bond. This may be an unpopular policy in Germany but Merkel must decide whether she wants to be in the Euro or out of it. If Germany decides it wants the Euro then it must back the Eurobond and the fiscal union, delaying the decision will only prolong the current economic deterioration.
Caballero, R. (2009, January 20). A Global Perspective on the Great Financial Insurance Run: Causes, Consequences and Solutions. http://econ-www.mit.edu/files/3745
Caballero, R., & Krishnamurthy, A. (2008, October). Collective Risk Management in a Flight to Quality Episode. The Journal of Finance, 2195-2230. http://econ-www.mit.edu/files/3679
Diamond, & Dybvig. (1983). Bank Runs, Deposit Insurance and Liquidity. Journal of Political Economy, 91(3), 401-419. http://rspas.anu.edu.au/~gfane/GF_Readings_IME2003/Diamond-Dybvig.pdf