Vanishing Liquidity, Market Runs,and the Welfare Impact of TARP

I model a financial market that dries out in the wake of premature liquidations. Two main results are obtained. First, liquidity may vanish even if small, riskneutral buyers could easily compensate the ongoing selling. Thus, more markets are vulnerable to “runs” than suggested by previous work. Second, the scale of premature liquidations is not informative about welfare losses. In fact, market runs may be nearly constrained efficient. The latter finding might suggest an explanation for the recent policy turn of the U.S. Treasury concerning purchases of troubled assets under the Emergency Economic Stabilization Act of 2008 (EESA).