Public Liquidity and Intermediated Liquidity

Abstract

Under financial constraints, firms hold liquid assets in anticipation of investment needs. Financial intermediaries supply liquid securities in the form their short-term debts. Endogenous liquidity creation stimulates investment and economic growth but generates intermediary leverage cycle that destabilizes the economy. Introducing government debt as an alternative source of liquidity is a double-edged sword. On the one hand, firms hold more liquidity in every state of the economy. On the other hand, by crowding out intermediaries' profits from liquidity provision, government debt induces intermediaries to reach for yield via procyclical risk-taking. As a result, the stationary (long-run) probability distribution tilts towards crisis states where intermediaries are undercapitalized and supply less liquidity. The latter force dominates, when public liquidity cannot satiate firms' liquidity demand and intermediaries are still the marginal liquidity suppliers. Contrary to the literature, this paper demonstrates an overall negative impact of public liquidity on both long-run growth and financial stability.

Keywords: Procyclicality, government debt, liquidity, leverage cycle, reaching for yield, financial instability, slow recovery

JEL Classification: E02, E22, E32, E41, E43, E44, E51, E58, E61, E62, G01, G12, G18, G20, G30