Can government create liquidity?

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Bernanke spoke recently of the Fed or the government or the tax payers creating liquidity in markets for assets that have closed down or locked up as prices have tumbled drastically. Another case is the interbank loan market that is drying up.

Bernanke is not talking about simply hyping the money supply. That is not the liquidity being referred to. He’s talking about the volume and depth of trading in an asset market.

Unfortunately, the Chairman’s knowledge of finance is abysmal. There is no way that the government or the Fed can create liquidity or jump start liquidity in a market by injecting liquidity. This is a false medical analogy. The Fed would have to enter the market and become an active participant in it, a dealer with a bid-asked spread. And once it did that, it could not make a price higher than the market price or else the rest of the traders would dump enormous amounts of securities in the Fed’s hands. The market would no longer even resemble a free market.

The financial concept that the Chairman is missing is that liquidity is endogenous to a market. It is not exogenous. Markets develop liquidity from within their own trading. It’s not something that is imported from outside of the actual trading.

Bernanke should search google for “endogenous liquidity” to find some research on this subject. Congressmen, pay heed. Do not attempt the impossible.

The rest of us should not accept the idea of an outside agent being able to “save” a market by injecting liquidity.

9:30 am on October 1, 2008