Katharina Pistor thinks the US Fed and the US Treasury have lost sight of their central, but not independent, role in financial markets

For centuries, the Catholic Church upheld the dogma that the world was flat and that the sun revolved around it, despite evidence to the contrary. It would take a technological, scientific, and cultural revolution to undermine this doctrine fully. Today, we are at a similar juncture when it comes to finance, where the orthodoxy of “flat” markets in pursuit of efficient outcomes maintains its grip on the minds of many economists and, more problematically, policymakers.

Consider US Federal Reserve Chair Kevin Warsh’s recent claim that markets should “play the ball, not the referee.” Warsh wants us to believe that the central bank is not an active participant in the making of markets and the creation of liquidity that sustains them, when obviously sovereign debt management and monetary policy are integral to the markets as they exist. It is little wonder that market participants were bewildered by Warsh’s remarks.

US Treasury Secretary Scott Bessent’s explanation for his recent attempt to reduce yields on long-term US Treasuries added to the confusion: “We are trying to keep the market in equilibrium.” (Predictably, his intervention failed.)

In fact, financial markets are not flat, and neither do they operate in a vacuum. They expand and contract in response to, or in anticipation of, actions taken by certain public and private players whose functions have always driven the evolution of credit markets. Chief among these functions are public debt management and public and private liquidity provisioning (money creation). In the context of the United States, the key players are the Treasury, the Fed, and the entire roster of private financial institutions, both domestic and foreign. It is they who jointly configure financial markets and the liquidity that sustains them.

In a recent paper I co-authored with Dario Laudati, William O’Connell, and Matthias Thiemann, we describe the entanglement of public and private actors in the making of modern credit markets as “liquidity triangulation.” We show that credit markets have always evolved through an interaction of public debt management and public and private liquidity provisioning, regardless of the identity of the entities or individuals that carry them out, and regardless of their beliefs in carrying out these functions.

Ever since the establishment of the Bank of England, liquidity expanded and contracted within this triangulated space, fueling the growth of credit and fostering financial and economic development. Liquidity is central for credit markets because it determines the ease with which one financial asset may be converted into another without affecting its market price. As Hyman Minsky famously quipped, “Everyone can create money; the problem is to get it accepted.”

For most of the postwar era, the US has enjoyed a privileged position as an issuer of both sovereign debt and US dollars that always found takers. But there are signs that this may be changing. With fewer foreign central banks willing to hold vast amounts of US debt, and with more private investors seeking to switch from sovereign debt to corporate-issued debt (to finance AI infrastructure), the liquidity triangle is being reshaped. Importantly, the process is not coordinated; rather, it reflects strategic action taken by different actors at each corner to advance their own interests.

Historically, one can find many cases of financial crises being triggered by such reconfigurations. The 2008 crash, for example, was brought on by private actors dumping the financial assets they themselves had created (mortgage-backed securities and their derivatives). When these assets no longer found takers, they became toxic. The Fed and the Treasury then stepped in to offer vast amounts of liquidity and recapitalization to stabilize the system.

But what if the US, the bedrock of the global financial system, can no longer rely on stable demand for its debt or its currency, which in turn is necessary to refinance old debt or take on new liabilities? Only when issuance and refinancing happen almost seamlessly will most participants feel confident enough to rely on the (relative) safety of US dollars or Treasuries. If this confidence is shaken, they will seek alternatives, without regard for the consequences for the entire system.

Bessent’s recent announcement that the Treasury would at least double the scale of its debt buybacks is telling in this respect. It suggests a fear that there may not be enough takers out there to ensure liquidity protect the price and of US debt as well as for the debt markets that depend on it (given the Treasury market’s central function as a benchmark and collateral for private debt). The US has never defaulted on its debt. But nor has it ever amassed as much debt as it has now, when confidence in the reliability of the US has been shaken, and when private actors (most prominently the tech sector) are issuing massive amounts of competing debt.

The mere possibility that new private debt might be crowding out public debt is an ominous sign, because it suggests that the “full faith and credit” of the US government is waning. That realization will leave the Fed in a bind, because in any future crisis, the refinancing of both private and public debt would fall into its lap for want of other takers. It may wish to pass on this put option, but who else could possibly fill the void?

The sooner that both the Fed and the Treasury understand their deep entanglement with each other and with the private sector, the better. They are not referees. They are players in a system that they helped create (albeit inadvertently). Their current role is to formulate meaningful strategies to make this entanglement manageable again.

Katharina Pistor, Professor of Comparative Law at Columbia Law School, is the author of The Code of Capital: How the Law Creates Wealth and Inequality (Princeton University Press, 2019).Copyright: Project Syndicate, 2025, published here with permission.