Permanent Liquidity |
28 September 2019 (latest revision: 22 June 2024)
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Liquidity in financial markets means you can buy or sell financial instruments like stocks and bonds at any time without delay. In other words, you can sell them in the financial markets for currency like euro or US dollar cash. During a financial crisis, liquidity evaporates, and you can't sell stocks and bonds. Their price collapses because there are only sellers and no buyers. To prevent that, central banks inject liquidity into the financial system. They print new currency, so euros and US dollar cash are plentiful.
It can end the crisis. Since the stock market crash in 1987, money printing by central banks has become a frequently used solution for financial crises. If currency is plentiful, short-term interest rates drop, and stocks and bonds become more attractive investments, so there will be buyers for them. Once interest rates are near zero, and the central bank can't lower them, a problem arises. Market participants will accumulate central bank currency because its zero interest rate is attractive.
They will not invest but hold on to their cash. With interest rates near zero, traditional methods of dealing with financial crises have become ineffective. That is why central banks adopted extraordinary measures like Quantitative Easing in the aftermath of the 2008 financial crisis and the 2012 euro crisis. Investors say, 'Cash is king.' It is the ultimate means of payment. If your bank goes bankrupt, your deposit might be gone. But you can still pay if you own banknotes, which are central bank currency.
During a financial crisis, people fret about whether their stocks might still have value in the future as the economy might collapse. That is why investors also prefer central bank currency. But that is only due to the interest rate on cash. Had there been a holding fee on the currency of 12% per year, investors would not prefer cash but anything else, and there would always be liquidity in the market. And the central bank doesn't have to do anything. We may not even need a central bank.
In times of crisis, there is a flight into safe financial instruments, so investors may gobble up government bonds. Central bank currency is unattractive because of the holding fee. Holding on the currency will cost you 12% per year. A euro turns into 88 cents after a year. And so, interest rates on government debt may go as low as needed, like -5%, and bring liquidity by ensuring that other investments become attractive. And so, there will always be liquidity.
Who needs currency then? No one wants to own it if it costs 12% per year to hold it. It will be the end of currency. At present, banks need currency for their reserve requirements. That is not necessary for financial stability. Equity requirements are more helpful than reserve requirements. And short-term government debt can do nicely as a reserve. Banknotes are also central bank currency. A 12% holding fee would make cash unattractive. Therefore, cash banknotes should not be central bank currency.