Flight to Safety or Liquidity? Dissecting Liquidity Shortages in the Financial Crisis

We differentiate the liquidity and the quality of private assets in a tractable incomplete-market model with heterogeneous agents. The model decomposes the convenience yield of government bonds into a “liquidity premium” (flight to liquidity) and a “safety premium” (flight to quality) over the business cycle. When calibrated to match the U.S. aggregate output fluctuations and bond premiums, the model reveals that a sharp reduction in the quality, instead of the liquidity, of private assets was the culprit of the recent financial crisis, consistent with the perception that it was the subprime-mortgage problem that triggered the Great Recession. Since the provision of public liquidity endogenously affects the provision of private liquidity, our model indicates that excessive injection of public liquidity during a financial crisis can be welfare reducing under either conventional or unconventional policies. In particular, too much intervention for too long can depress capital investment.