Wednesday, August 29, 2007

Defining "liquidity" 

Alex Pollock tries to do so in yesterday's Financial Times:
But the real confusion derives from the fact that "liquidity" is a misleading metaphor. This metaphor suggests that there is some "flowing" substance, which could be a "flood", could "slosh around", or could be "pumped" somewhere. But if liquidity were substantive, there could not have been plenty of it a few weeks ago and a shortage now.

[L]iquidity 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.
I use a graph in my money and banking course in discussing the theory of asset demand, reproduced at left. I can sell my house right now ... for $1000. If I wait until tomorrow, a sign offering it for $5000 might find a buyer. If I want to find a buyer for what we might call "fair price", on the other hand, I have to wait a while for someone to find it, prove its value to someone else who will lend the money, and draw up contracts to complete the transaction. Liquidity, in short, is a function of time, and this is how I've drawn the graph.

The point here is that in the world Pollock describes, liquidity simply means it takes longer to find the buyers willing and able to purchase an asset, and this drives down the price of all assets, not just the ones that are more risky. My house isn't any less a good now than it was two months ago -- it still produces the same level of household services -- but if I wish to sell it within 90 days of listing it, I would have to offer it for less money than I would have then even if there are no more houses on the market now than two months ago.

This is why temporary injections of credit by a central bank can help; they may increase the number of buyers who can purchase assets in a normal amount of time by decreasing the number of lenders they would need to visit to obtain funds.

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