Private and Public Supply of Liquidity (Journal of Political Economy, Vol. 106, No. 1, February 1998)

"Holmstrom and Tirole make two points that are relevant to our conversation. First, how do you get around the moral hazard problem, or at least reduce the severity of that problem? In Holmstrom-Tirole, this is done by seeing that the owners of a bank investing in risky projects bear some of the risk themselves. The bank is in the business of investing its depositors’ money in such projects. But unless its owners – the equity holders – also put up a stake, the bank won’t have the incentive to invest the deposits wisely. Second, Holmstrom and Tirole identify a role for government beyond providing deposit insurance. In their model, the risky projects that banks invest in may turn out to require a further infusion of capital later on. If some projects need more capital, but others don’t, then banks can work out an insurance arrangement: they can all put a little additional capital aside and this capital can then go to the banks whose projects need it. But let’s imagine that all the projects need liquidity at the same time. This can set off a financial crisis – everyone demanding liquidity simultaneously. Holmstrom-Tirole show how the government can step in to provide the extra financing and stop all these projects from grinding to a halt. The current crisis started with a sudden drop in liquidity in financial markets (we’ll talk about the reasons for that drop later). And to prevent the projects sustained by financial markets from shutting down, someone had to come up with the missing liquidity. In the US, that someone was the government. So, the US government acted in the way that Holmstrom and Tirole said it should. I don’t accept the criticism that economic theory failed to provide a framework for understanding this crisis. Indeed, the papers we’re discussing today show pretty clearly why the crisis occurred and what we can do about it. The sort of economics that deserves attack is Alan Greenspan’s idealised world, in which financial markets work perfectly well on their own and don’t require government action. There are, of course, still economists – probably fewer than before – who believe in that world. But it is an extreme position and not one likely to be held by those who understand the papers we’re talking about"