Working Papers

The Use and Abuse of ‘Liquidity’

The notion of ‘liquidity’ is routinely invoked as a driver of the business cycle and asset prices, yet few analysts bother to define what it is they mean by liquidity.  More often than not, ‘liquidity’ is discussed in a way that is simply synonymous with monetary policy.  To that extent, there is nothing remarkable about the idea that monetary policy might be important for business cycle and asset price dynamics.  Many of the analysts who invoke liquidity intend the term to mean something more than monetary policy, defined narrowly as changes in official interest rates.  In particular, the notion of liquidity is often employed to denote growth in monetary and credit aggregates, which may have only a tenuous relationship with monetary policy and may be dominated by private choice. 

Then there are those who conflate liquidity with saving.  The idea of glut of global saving has led some to claim that the world is ‘awash in liquidity.’  But as Alex Pollock notes ‘if liquidity were substantive, there could not have been plenty of it a few weeks ago and a shortage now.’  Pollock argues instead that:

“liquidity” is a figure of speech, describing the following situation:

• A is ready and able to buy an asset from B on short notice
• At a price B considers reasonable
• Which usually means C has to be willing to lend money to A
• Which means C believes A is solvent and the asset is good collateral
• And if A is a dealer, A and C both have to believe that the asset could be readily sold to D
• Which means they both have to believe that there is an E willing to lend money to D.

In short, liquidity is about group belief in the solvency of counterparties and the reliability of prices, reminding us that “credit” and “credo” have the same root. When no one is sure who is broke, and there is high uncertainty about prices, we will discover that liquidity has vanished, however plentiful it may recently have seemed.


posted on 29 August 2007 by skirchner in Culture & Society, Financial Markets

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Interesting post, Stephen. As a non-financial economist, I have often puzzled over the meaning of the term, which is used so liberally and in so many different ways by the media. No doubt what Pollock says is true, but what is it that gives rise to the ‘reliability of prices’? I’ve always thought that liquidity imports some notion of price-taking, in that there are many buyers and sellers, so that one can acquire or dispose of an asset without greatly influencing the price one pays or receives. For example, BHP shares are more ‘liquid’ than XYZ mining minnow company shares because there are many more BHP shares in existence and I can buy or sell them without affecting their price. Similarly, a Paddington terrace may be more liquid than a Point Piper mansion because there are many potential buyers of the former but not so many of the latter. I think it was Edgeworth who showed how increasing the numbers of trading parties reduced the range of indeterminacy of relative prices.
At a macroeconomic level, I think many commentators refer to liquidity to mean strong growth in credit aggregates brought about by the combination of monetary policy and exchange rate policy - the idea being that global interest rates would be higher and monetary aggregate growth lower if Asian and OPEC governments allowed their currencies to appreciate. Perhaps this does confuse liquidity with (forced) saving.

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