Or, how central banks become passive
Great primer in central banking. Question: hasn’t the Fed always been in the business of making sure the Federal government can finance itself? I’m thinking of the world wars. Like the March 2020 episode, bond purchases and/or yield curve control are “temporary” measures. Is fiscal dominance a cyclical phenomenon? Thanks
"It is not clear to me why liquidity differences wouldn’t show up in prices and to the extent these differences create arbitrage opportunities, these differences should be arbitraged away."
The whole issue though is that this is not what happens. Arbitrage in big markets isn't a small game, it's a big game. Meaning, many financial markets are not retail markets that anybody with a few bucks can participate in., but rather are wholesale markets that only large institutional players are involved in. And when dealers/market makers are in a crunch, cross-market arbitrage completely stops, and the result is potentially a self-reinforcing debt deflation, where lack of liquidity leads to asset firesales, and therefore insolvency, and therefore less liquidity, and so on.
So, it's not sufficient to just *assume* that arbitrage will happen, we have to consider *who* is doing it, whether they are in fact able to, and what happens if they can't. This is what Mehrling talks about with his "dealer of last resort" terminology.
Finally, from the point of view of political economy of public purpose, it's *good* that the central bank supports liquidity for government liabilities. Even if you believe in fiscal discipline, my opinion is that it does not ultimately make sense to try to impose it via a quantitative constraint on liquidity of government instruments. That's a monetary solution for a political problem. What we want is to have political limitations on the government that keep it on the right track (perhaps including delegation of macroeconomic management to administrators, if you believe in that kind of thing), and then ensure that the financial plumbing situation will always work out underneath that as needed.