As the Volcker Plan
limps through Washington and many are screaming bloody Armageddon, an idea has been floating through my head. This is an idea that is sure to really rile up those on Wall Street, many readers of this blog, and followers on Twitter. It is an idea that at the onset seems ridiculous but after pondering for some time has some merit. This idea is nationalizing market-making in vanilla financial instruments.
Liquidity is to the flow of capital as as roads are to the flow of traffic. Most would argue that both the flow of capital and the flow of traffic are both vital to economic well-being. Yet unlike in transportation, in markets we largely leave our market infrastructure up to the private sector. While provision of transportation infrastructure would not pass the public policy test of a pure public good, many would agree that is important and government has a inherent interest in making sure that traffic flows. Why not leave this role up to the government in the capital markets?
Below are some reasons why this idea keeps banging through my head:
Additional Tools for Policy Makers
Over the past 20 years we have experience multiple liquidity crises where the Fed has had to step in and provide liquidity to financial institutions so that they could turn around and use that money to get the markets moving again – aka make markets. The government is already somewhat on the hook as a "liquidity provider of last resort" to the markets, so why not do it all the time.
Think about the additional tools it would give policy makers. Markets getting bubbly? Increase your spreads. Capital not moving? Decreae your spreads. Too much debt being issued? Shift market making capital to equities. Want to create the incentive for Alternative Energy companies? Make liquid markets in their debt and equity. The private sector would never do this. They make markets in wherever it is most profitable at the time. Sometimes to aid other businesses that they are in and can get out of the game in a moments notice.
Steve Waldman at Interfluidity writes that Information is Stimulus:
A housing boom, any kind of boom, is attended by an increase in certainty. Information is stimulus, confusion is contraction. A bust occurs when the market is unsure of everything, when market participants perceive better risk-adjusted return in holding government securities (or supply-inelastic commodities) than in financing real investment. Sectoral shifts per se have no clear implication with respect to variables like employment and output.