The free banking alternative to the centralized provision of lender of last resort services

Inspired by Perry Mehrling and Fischer Black:

I think I'd take your future ideal financial model even further (slide 9). The C5 in your model provides what you call liquidity puts. I see no reason why these liquidity puts need be provided by a central bank. In the future, financial products called liquidity options - the option to buy or sell some asset (say Apple stock) at a guaranteed point in the bid-ask spread - would be popular financial products traded on organized exchanges. Just as Apple CDS allow investors to split off Apple credit risk and distribute it across the economy, so would Apple liquidity options split away the liquidity risk of transacting in Apple stock in the secondary market and evenly distribute this risk to those willing and capable of holding it.

A private liquidity options market has some advantages over a monopoly last resort system. Liquidity would be competitively priced and no longer supplied in an opaque manner. Central banks would either vacate the market for liquidity services or price their liquidity products off the private liquidity options market. Subsidies to or penalties on institutions anxious for liquidity insurance would be a thing of the past.

If central banks were to cease providing liquidity options, their sole role in the future would be as managers of the clearing and settlement system. The provision of paper money can be easily fulfilled by private banks. I guess central banks would also have to manage the price level.

The above is a free-banking view of the world. The lender-of-last resort role is transferred from central banks to private markets. It is distilled into just another financial product.

Thinking in terms of stocks: From Fisher to Fischer

In an older post, Scott Sumner had an interesting comment:

The most recent inflation rate in Greece is 1.7%, whereas Spain has 1.9% inflation. I don’t know about you, but I find those figures to be astounding. That’s not deflation, and yet Tyler’s clearly right that they are being buffeted by powerful deflationary forces. I’d make several observations:

1. This shows the poverty of our language. Economics lacks a term for falling NGDP, even though falling NGDP is arguably the single most important concept in all of macro, indeed the cause of the Great Depression. So we call it “deflation” which is actually an entirely different concept. I wouldn’t be the first to find connections between the poverty of our language and the poverty of our thinking.

Fisher Black's dream

Perry Merhling had an interesting quote from Fischer Black:

Thus a long term corporate bond could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk; and one would bear the risk of default. The last two would not have to put up any capital for the bonds, although they might have to post some sort of collateral

In the comments I pointed out that a fourth person can be added to the list - someone who bears the liquidity risk of that corporate bond in the secondary market. This would amount to a liquidity option. Essentially, the bearer of liquidity risk would allow the bond owner to sell that bond at some preset level in the bid-ask spread. For instance, the option could allow the bond owner to immediately sell their entire bond holdings at the upper end of the spread, or at the ask price. Normally, sellers can only sell quickly if they accept a price near the bid price, or lower end of the bid-ask spread. When illiquidity strikes and spreads widen, usually because buyers depart and there are less bids, an option to sell at the ask price rather than the bid price increases in value.