Dimon, now Summers: There's a liquidity problem (Why don't I trust these jerks?)

[rogerashton]

4. Let's see if I can fill in some blanks.

I was recently reading some of Summers' recent writing on "secular stagnation" which is not going to encourage the financial elite.

http://www.voxeu.org/sites/default/files/Vox_secular_stagnation.pdf

So: all financial instruments are more or less risky. The main real way of reducing risk is to share it. As long as the risks are independent, the risk-sharing agreement is less risky than the individual risks shared. This is the principle behind diversification and insurance. For example, investing in municipal bonds, you can reduce your risk of losing to municipal bankruptcy by buying a mutual fund that buys bonds of many different cities.

Risk can also be avoided if there is a very active market for the financial instruments. Then you can sell out quickly if you smell a rat. But who will want to buy? For that reason, the riskier the instrument is, the less likely it is traded in an active market.

If an instrument has relatively low risk and an active market we say it is relatively "liquid." Money is the most liquid of all assets. Like money, government bonds bear some risk of loss of purchasing power to inflation, but all other bonds share that risk, so that, in a country that prints its own money as the US does, government bonds are very safe and liquid.

Summers argues that changing regulations have increased the demand for safe, liquid assets while the supply has dropped. This forces the interest rate of the safe, liquid assets down near the zero lower bound. Summers argues that this leads to "rational bubbles" and thus instability -- danger of another crash.

The Swiss have tried another solution -- taxing safe, liquid assets. That lowers the rate of return below the "zero lower bound" and might help. Perhaps a general wealth tax would help. I don't think Summers has taken a position on those ideas, but I might have missed it.