MIT Sloan professor finds government injections of liquidity into the market may decrease market efficiency

CAMBRIDGE, Mass., June 26, 2008 — Government interventions to directly inject liquidity into the market may actually decrease market efficiency, according to new research by MIT Sloan School of Management Professor Jiang Wang. Wang advocates instead that the government persuade financial institutions to collectively agree to increase liquidity on their own, which, as his findings support, has the potential to improve the long-run welfare of the economy.

In a new research paper examining the different policy tools available for responding to market crises, coauthors Wang and Jennifer Huang of McCombs School of Business at the University of Austin state that concern for the overall economy is why some argue that the Fed should bail out banks currently in jeopardy.

“When market prices drop, you'd like to see money stay in the market, as well as new money coming in to buy assets when they are cheap in order to stabilize the market,” says Wang, a professor of Economics, Finance and Accounting at MIT Sloan. “But what you typically see are people running away from the market and prices dropping even more. The concern is that this will trigger panic in the market and cause losses for investors and financial institutions. And it might have broader reaching effects like shrinkage in credit that will hurt not only financial institutions but also firms and households in general — this is the scenario people are worried about.”

While the authors find that lowering the cost of supplying liquidity on the spot can decrease welfare by reducing the profit opportunities for market makers, and thus the incentive for them to be there, forcing more liquidity during times of crises can improve welfare. The key distinction, however, is that agents should not expect to be subsidized during crises, better ensuring that the anticipation of future interventions would not hinder their incentive to supply liquidity.

Wang concludes that in the current credit market upheaval, the best government intervention is persuasion. “It would be ideal for banks to get together to raise new capital and put in more liquidity to stabilize the market themselves,” says Wang. “Individually, they probably wouldn't do it because they don't want to bear the costs alone. And since the cost and benefit may be different for each bank, it may be hard to get them to agree through negotiation. It could be more efficient for the government to persuade them to coordinate because everyone would benefit in the end.”

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