Against liquidity

By Felix Salmon
November 27, 2009
Paul Krugman today argues in favor of a financial-transactions tax on the grounds that it would discourage over-reliance on ultra-short-term repo markets, among other reasons. In other words, reliance on repos is a bad thing, and it's a good idea for government policy to "nudge" financial institutions away from it.

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Paul Krugman today argues in favor of a financial-transactions tax on the grounds that it would discourage over-reliance on ultra-short-term repo markets, among other reasons. In other words, reliance on repos is a bad thing, and it’s a good idea for government policy to “nudge” financial institutions away from it.

That’s something that opponents of the Miller-Moore amendment should bear in mind, when they complain that it could hit the repo market hard. Here’s Agnes Crane:

The repurchase agreement, or repo, market is a critical source of financing for dealers, hedge funds and others who use leverage to finance short-term trading positions. It’s a source of extra income for those holding virtually risk-free securities since they can squeeze out extra return by lending them out.

Such financing makes for a deeper and more liquid market that gives investors confidence that if they buy a Treasury note, for example, they can quickly sell it if they want to.

The problem is that we don’t want to encourage the use of leverage to finance short-term trading positions. Indeed, from a public-policy point of view, we’d ideally want to discourage it.

Would a less liquid repo market mean, in turn, a less liquid Treasury market? I daresay it would. But that’s no bad thing: the more liquid the Treasury market, the more that investors flock to it in times of crisis, exacerbating the systemic downside of the flight-to-quality trade, and reducing the amount of liquidity elsewhere in the markets, especially among credit instruments.

There are serious systemic consequences to living in a world where a Treasury bond — or any asset, for that matter — is considered a safe haven from all possible harm. Investing shouldn’t be about safety: it should be about calculated risk. Excess demand for triple-A-rated risk-free assets, as we’ve seen over the past couple of years, can be much more systemically damaging than excess demand for risky assets like dot-com stocks. So yes, let’s throw some sand into the wheels of the repo market, either through a Tobin tax or through the Miller-Moore amendment or both. Because liquidity is not ever and always a good thing.

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