NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Liquidity, Efficiency and Bank Bailouts

Gary Gorton, Lixin Huang

NBER Working Paper No. 9158
Issued in September 2002
NBER Program(s):   CF

Why do governments bailout banking systems in distress? We argue that the government can efficiently provide liquidity. We present a general equilibrium model in which not all assets can be used to purchase all other assets at every date. At some dates agents want to sell projects or securities. The only buyers are agents who have previously opportunistically invested in otherwise dominated assets because only these ( liquid') assets can be used to purchase the projects or securities. The market price of the projects or securities sold depends on the supply of liquidity, which is determined in general equilibrium. The supply of liquidity is not perfectly elastic so asset prices can deviate from efficient market' prices, that is, the conditional expectation of the asset payoff. While private liquidity provision is socially beneficial since it allows valuable reallocations, it is also socially costly since liquidity suppliers could have made more efficient investments ex ante. As a result, there is a potential role for the government to supply liquidity by issuing government securities, backed by tax revenue. Government bailouts of banking systems are an example of such public liquidity provision.

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Document Object Identifier (DOI): 10.3386/w9158

Published: Gorton, Gary and Lixin Huang. "Liquidity, Efficiency, And Bank Bailouts," American Economic Review, 2004, v94(3,Jun), 455-483. citation courtesy of

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