Liquidity, Time Preference, Brad DeLong, and the missing $20 trillion

Brad DeLong has an excellent short essay on the financial crisis. Read it.

I disagree with one part of it:

Liquidity Discount: The cash flowing to capital arrives in the present rather than the future, and people prefer — to varying degrees at different times — the bird in the hand to the one in the bush that will arrive in hand next year. Fluctuations in this liquidity discount are yet a fourth source of fluctuations in global capital wealth.

That's not liquidity; that's time preference. Liquidity can explain the missing $20 trillion, even if time preference can't.

Just to be sure I've understood him correctly, let him explain further:

As far as the liquidity discount (4) is concerned as long as we love our children as ourselves (and most of us do) and as long as we have access to and can credibly pledge collateral for financial transactions (and we can) the magnitude of the liquidity discount should be roughly equal to the technologically and organizationally driven rate of labor productivity growth divided by the intertemporal elasticity of substitution. The technologically and organizationally driven rate of labor productivity growth is a fairly steady 2 percent per year. The intertemporal elasticity of substitution is in the range from 1/2 to 1. The liquidity premium should be in the range of 2% to 4% per year in real terms — and no central bank should be able to drop it to 2% per year by a few open-market operations: big moves in the liquidity premium should require big moves in expected future growth rates of consumption.

Yep, he's definitely talking about time preference: we would rather have extra consumption today than 10 years from today.

Now the liquidity discount is something quite separate from the time preference discount. Changes in the liquidity discount could have changed the value of assets, even if time preference stayed the same.

Money is the most liquid of all assets. Over the last 15 years of inflation targeting in Canada, inflation has been 2%, and money (paper currency) has earned 0% nominal interest (and minus 2% real interest). Government bonds, which are very liquid, though not quite as liquid as money, which are very nearly as safe as money (safer, if the chance of getting robbed is higher than the chance the government will default), have earned 4% or more. That's a 4% spread for a small change in liquidity. Most of my assets, my stocks, house, land, and especially my human capital, are much less liquid than bonds.

In the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion.

How big a change in the liquidity premium would it take to drive that size of change in the valuation of the global capital stock? Given an unchanged flow of permanent future earnings from that capital stock (in other words, just for the sake of argument, let's ignore the recession) the discount rate applied to those future earnings would need to increase by one third, or 33%. Note that I said by 33 percent, not by 33 percentage points. So if the discount rate increased from 10% to 13.3%, that would do it. Or from 6% to 8%. Or from 3% to 4%. 3% of $80 trillion equals 4% of $60 trillion.

Now is that sort of increase in the average liquidity premium plausible? What could have caused it? Maybe an increase in the demand for liquidity? Maybe a decrease in the supply of liquidity? Or maybe that assets actually became less liquid, so the average asset became less like money and more like my house. That seems the most plausible.

Illiquid assets have big bid-ask spreads. If you try to sell a lot of them very quickly, you sell them for a lower price than if you can wait a bit and sell them slowly. And just to make sure we are not talking about time-preference, the same is true if you try to buy a lot of illiquid assets very quickly, except you will pay a higher price than if you are prepared to wait a bit and buy them more slowly. Liquidity matters. If you think you might need cash in a hurry, you will need a lot higher rate of interest to persuade you to hold your wealth in illiquid assets.

In the last few months, that's exactly what we have seen. Markets became shallow, and some even dried up completely. Bid-ask spreads widened. So most assets became a lot less liquid than they were before. So the required rate of return increased. So asset prices fell. It would only take a small reduction in liquidity, less than the difference in liquidity between money and government bonds, to be big enough to wipe $20 trillion off global asset values.

The exception proves the rule. Very short term US government bonds, T-bills, stayed very liquid. And their rate of interest fell to zero. Interest rates on long US bonds stayed about the same, or fell a little. It wasn't an increase in time preference; it was a fall in liquidity of all the other assets.

Why liquidity fell is another question.

UPDATE: Here's an explanation of why liquidity declined.

Comments

[Andrew F]

Apologies for the off-topic comment, Nick/Stephen. Given that your blog is growing in terms of posts and comments, would it be possible for you to add a 'recent comments' list to make it easier to see on-going conversations?

[Stephen Gordon]

Done!

Gotta get around to doing more updates like this. Almost everything is set at typepad's defaults.