Why does liquidity matter so much?

This question has been bugging me for the last few months. I see the financial crisis as largely a liquidity crisis. People only want to hold the most liquid assets, and shun the illiquid. So liquid assets have high prices and low yields; and illiquid assets have low prices and high yields.

But if we think of liquidity in terms of transactions costs, it is hard to see why people would pay so much to avoid holding illiquid assets. The transactions costs don't seem big enough to justify the yield spreads. A 1% extra transactions cost would only justify a 1% yield spread if you expected to hold the asset for one year. So you would need really big differences in transactions costs, or really short expected holding periods, to explain any significant yield spread between liquid and illiquid assets. Neither seems plausible.

Perhaps it's not transactions costs, or not just transactions costs, that determine differences in liquidity. Perhaps it's the fear that my need to sell the asset to raise cash may be correlated with other people's need to sell the asset to raise cash. If our needs to raise cash are correlated, the market price will fall at exactly the wrong time. A 10% fall in the market price if I ever needed to sell the asset would have the same effect on liquidity as a 10% transactions cost.

You can still think of illiquidity as high costs of making a "round trip". You buy the asset, then sell it again, and see what percentage of your money you have lost in making the round trip. Only this time, you consider not just the transactions costs but the probability that other people may be selling the asset at the same time you are, so the market price falls when you sell. An asset whose price is expected to fall 10% if you need to sell it has the same effect on the round trip as a 10% transactions cost.

Even if 1 year and 10 year bonds had exactly the same transactions costs, the former would be more liquid, even if you needed cash today, and could not wait 1 year till the bonds mature. That's because if the people holding them needed cash today, the price of the 10 year bond would need to fall 10 times as much as the 1 year bond to get the same increase in yield, and make them attractive to the people who didn't need cash today. So the difference in liquidity would cause a yield spread in the term structure, even if people expected interest rates to stay the same.

Even if simple bonds (understood by everyone) had exactly the same transactions costs as complicated bonds (understood by a few people), the former would be much more liquid. The complicated bonds would only be held by the people who understood them. If a substantial portion of those people needed to sell at the same time, the price would have to fall a lot before others would be willing to buy them. So complicated bonds are less liquid, and would have a higher expected yield.

Why should my need to sell an asset and raise cash be correlated with other people's need to sell the same asset and raise cash?

In normal times it isn't correlated (or will have a low correlation). Individuals' needs for cash will be idiosyncratic, and so uncorrelated. A big bill comes due. My car breaks down. I lose my job. I retire. If individuals' needs to sell an asset and raise cash are uncorrelated, transactions costs alone determine liquidity. Brokers' and agents' fees, bid-ask spreads, and things like that, are the only things that determine liquidity. And since transactions costs for most assets are fairly small, most assets are fairly liquid.

But in abnormal times, with a greater risk of aggregate fluctuations, individuals' needs to sell an asset and raise cash will be correlated. Many people lose their jobs. Many people face a margin call. Many banks run short of capital reserves. The risk of an asset falling in price just when you need to sell it, because other people (or firms or financial institutions) will also need to sell it, becomes much greater. So previously liquid assets become much less liquid, even if the transactions costs stayed the same.

If people believe the business cycle has been tamed, so aggregate risk falls, previously illiquid assets come more liquid, and the spreads narrow.

If aggregate risk reappears, liquidity spreads become much bigger, for two reasons. First, because any given asset, except those that are most like cash, will become less liquid than it was before. And second, because the average liquidity of assets has fallen, the supply of liquidity has fallen, people will place a greater marginal value on the remaining liquidity.

If my story is correct, the very low yields on short-term treasury bills are not due to a glut of savings and a dearth of investment opportunities (or not solely due to savings and investment). They are low because there is a shortage of liquidity, and people value liquidity more at the margin, and are willing to pay more for it with lower yields. The interest rates which matter for consumption and investment decisions, and for aggregate demand, are not zero. There is an "illiquidity tax" on aggregate demand.

And the policy implication is to reduce that illiquidity tax: use quantitative easing to increase the total supply of liquid assets (money is of course the most liquid), and to make illiquid assets more liquid by buying them when others need to sell.

It's the same story I have told before, of course, but I now think I understand liquidity better. It's not just transactions costs. It's much bigger than transactions costs, and big enough to matter. So I'm now more confident my story makes sense.

Comments

[Adam]

Nick,

before you said: "Regardless of the model (at least, regardless of any vaguely reasonable model I can think of), quantitative easing will be more effective if it is expected to be at least partly permanent, rather than temporary."

Now you're saying: "I see the financial crisis as largely a liquidity crisis. People only want to hold the most liquid assets, and shun the illiquid."

If it's just liquidity then what does matter if the easing increased supply of liquidity is permanent or not? I mean, you have excess demand for liquidity that the central bank needs to fill. The increased supply of liquid assets (money) needs to last as long as the demand to hold it is high which may well be forever, but is that what we expect? Do agents really believe that they will never again want to hold less liquid but higher yielding assets?

In a pure liquidity story agents only need to believe the extra money supply will last as long as their demand for holding it, in this case you (and the agents) want the central bank to take the money back when agents stop demanding so much of it, that way you can avoid inflation. The two quotes above seem to me to be inconsistent with each other.

[Richard]

Peter Drucker once said that every successful strategy contains the seeds of its own demise. I believe this is true in part because every successful strategy includes blinders. If we successfully figure out how to maximize profits, we allow our balance sheet to become distorted. When the balance sheet gets beyond a sustainable distortion, liquidity problems overwhelm the profit problems and a new strategy must be developed. Perhaps quantitative easing will provide a successful strategy for the problems defined as liquidity. It appears to me that the balance sheet distortion is continuing apace. And now profits are suffering. It seems to me that we should be pursuing sustainable strategies rather than successful strategies. But this is much harder to describe, let alone maintain.

[Nick Rowe]

Adam: I fear you may be right. I am stumbling around in the dark, trying out different perspectives on the elephant, and these perspectives may not always be consistent. Maybe not out-and-out logically inconsistent, but certainly a difference in emphasis. I don't think there's a logical inconsistency here, because both current and expected future monetary policy may matter, and if they do, then expected permanent changes will have a bigger effect than temporary changes. But I do need to make my mind up over whether it is current or expected future changes that matter the most. And I need people like you to point out those inconsistencies.

Richard: is the strategy that contains the seeds of its own demise the strategy of private individuals and firms, or of the government and central bank? Or both? I am thinking more Minsky than Peter Drucker.

[Don the libertarian Democrat]

"In a pure liquidity story agents only need to believe the extra money supply will last as long as their demand for holding it,"

"But in abnormal times, with a greater risk of aggregate fluctuations, individuals' needs to sell an asset and raise cash will be correlated."

http://www.newscientist.com/article/mg20127001.200-why-money-messes-with-your-mind.html?full=true

"In his book Nudge, co-authored with legal scholar Cass Sunstein, also at the University of Chicago, Thaler identifies other irrational biases that lead to distortions in our mental accounting. Almost all of us, for example, are "loss averse" - it hurts more to lose £50 than it feels good to win £50. We also value money in relative rather than absolute terms - we consider £10 irrelevant when buying a house but not when paying for a meal. Similarly, finding £100 will give many people more pleasure than having a heating bill cut from £950 to £835, even though this gains them more in real terms.

We also have a well-known bias in favour of a little money now over more money later, which makes saving so difficult. Thaler has suggested - and many companies are now using - a scheme called "Save more later" that puts this bias to work. Employees can commit themselves to putting more money into their retirement savings in future years, rather than doing it now. It seems to work for the same reason that we are lured by offers of "no payments for the first year", but in a more beneficial way"

The Flight to Safety is just that. The escape velocity, if you will, to fear and aversion to risk, might well necessitate a compensating factor of permanence.

[Joe]

I've often wondered (at the risk of sounding like David Foot) whether demographic effects (esp. cohort size) are large enough to make a difference in this regard. Presumably some of the past run-up in equity prices had to do with boomers saving for retirement, and that even without the current crisis there would have been a lot of correlated selling of stocks over the next decade. I'm curious whether the differences in cohort size are large enough to make a significant difference in prices though.

It would seem to affect housing as well. I remember shopping for a house in Toronto in the mid-90s, when there were a huge number of "starter homes" on the market, at prices below what the boomer owner had paid in the 80s. Now there are a lot of big homes sitting on the market, from "empty-nesters." When I sold my house last year, I was surprised at how much you could get for the "starter," and how small the premium was required to move up to one of the big ones. I figure there has to be a demographic effect here. There is a tendency to talk about "housing" as though it were a single good, or else a good that varies in some kind of continuous manner. A better approximation would be to think of the housing market as containing maybe five different types, each one a moderately close substitute for the other. It's quite possible for investments in different categories to vary enormously with respect to liquidity (determined, in part, by the substitutions that people are making).

[Account Deleted]

Nick,

"If my story is correct, the very low yields on short-term treasury bills are not due to a glut of savings and a dearth of investment opportunities (or not solely due to savings and investment). They are low because there is a shortage of liquidity, and people value liquidity more at the margin, and are willing to pay more for it with lower yields"

This is not the main reason for the low yields on short-term treasury bills ... it is safety! liquidity comes second .... in the sense that if it is safe only liquidity counts. So the willingness to pay more is for the safety ..

Also coming back to the importance of liquidity .. it will not help!!

The reasoning is as below:

more buyers ---> less goods --> costs going up -- from 2003 to 2007

liquidity helps here as it enhances the ability of the buyer to buy thus increasing the demand and prices (inflation)!! While liquidity helps here, the key is the buyer psyche!!

less buyers ---> more goods ---> costs go down ..

job losses, economic uncertainty, erosion of wealth, investor psyche badly bruised, high level of indebtedness, lack of lending, tighter standards, reduced ability to pay ---> all points to less buyers ... the only way to increase buyers here is to create a sub-prime category across all product groups (may work as banks know uncle sam is behind them)

more goods as production capacity is from earlier levels & unsold inventory, time taken to close plants, reduce production etc. ---> this is coming down through closure of plants, unfortunately accompanied by job losses ... lowering the number of buyers

all this portends to a cliff-diving of buyer psyche ... and therefore lower demand, lower price (deflation)

for this to improve, you need to stop jobs losses (which may be followed by salary cuts .. reducing buyer power and psyche), economic uncertainty and erosion of wealth.

Thus turn in the buyer psyche is more important than liquidity!

This cannot happen through liquidity but through asset finding a floor price.

when will this happen?

If you ask me this will happen only when the asset prices fall to its lowest level possible. At that point there will be stability in terms of job losses, wage cuts, economic uncertainty (i.e. only way to go is UP!) and stop in the erosion of wealth

thus the best way out would be to allow the value of the asset to fall and then wait for the recovery to happen soon after.

Thus asset safety and buyer psyche would be more important than liquidity!!

I feel that the only good thing about all the intervention across the globe has been that it has averted the collapse of the global financial system. Having achieved that, the only sensible thing that the Fed can do now is get down to an orderly winding down of all the systemically important firms!!

[Patrick]

Maybe another way of thinking about liquidity preference is in Darwinian terms. When everyone rushes for the exits, the penalty for illiquidity is death. Death is such a terrible outcome that any perceived possibility of it's occurrence outweighs all other considerations; the agent will forgo any and all possible future returns to minimize the risk of death (e.g maximize liquidity).

When the economy is humming along, nobody fears that there will be a mad rush to the exists. But if something bad and unexpected happens (alien invasion, Lehman BK), then suddenly the fear of death sets in and there is a discontinuity in behavior and before you know it you have a liquidity trap.

Kinda sounds like the paradox of thrift: the more fear of illiquidity there is the more illiquidity there is and everyone ends up dead in a liquidity trap.

[Neville]

Your account of the role of liquidity is persuasive and helpful.

There's a problem though with this:

"the policy implication is to reduce that illiquidity tax: use quantitative easing to increase the total supply of liquid assets"

By your own account the way to make my illiquid asset more liquid now would be, by doing something now, to increase the supply of liquidity at the time of the next financial crisis, not this one. Yet in the real world this is quite absurd.

Eventually we will accept that deleveraging has to happen and will cause a lot of changes, as has repeatedly been the case throughout history. All the political fighting is about which constituencies are going to have their incomes protected as GDP resets to a lower level, and what compromises those constituencies are willing to make to help it grow from that point.

[the buggy professor]

Nick:

1) Very well done, this analysis of yours. It echoes what Irving Fisher, the greatest American economist of the first half of the last century, said in the early years of the Great Depression --- before FDR came to power in 1933. He distinguished between asset-deleveraging and debt-deflation.

The former --- declines in all sorts of asset prices that had risen excessively in the 1920s housing boom and stock marking boom (the latter something he denied just before it collapsed in November 1929) --- has been happening in the US and elsewhere for over a year now. In some states, like California, the decline in house-prices has probably reached its bottom; at any rate, house sales are up well over 30% in January and February this year compared to the same months in 2008. The latter, debt deflation, is what you're talking about.

.....

2) Fisher was the first to fully clarify what is involved in such debt-deflation.

Debts are contracted in nominal interest rates. In a general drop of the aggregate price level --- in the US well over 40% in the years between 1929 and 1933 --- the real interest rate keeps rising. Hence the pell-mell scramble your story singles out: as each individual seeks to sell assets such as houses whose purchases they made on borrowed money, the prices of those assets keep falling. It's a vicious cycle: the more the prices fall, the more people with fixed and long-term assets (in some instances, even very short-term ones) scamper to sell them, the faster the real interest rate rises.

Hence the flight into the one asset --- currencies --- whose purchasing power grows amid deflation. Which is another word for liquidity preference.

....

3) Fisher, whose reputation declined in the 1930s and 1940s --- only to make a big return in the last few decades --- was the true father in many ways of modern monetarism . . . including the first to emphasize the complexities of financial intermediaries as the wedge between aggregate demand and aggregate supply and hence the refutation of Say's law. Keynes knew his work. He was in fact, according to some studies, the most cited economist in the world --- not just in English, but in French and German economic journals --- until the early 1930s.

Fisher was also the first to opt for a rule-based kind of monetary policy --- which became the heart of modern monetary policy since the 1980s (until the current crisis).

And like Keynes, his interpretation of the huge plunge in money-velocity between 1929 and 1933 was exactly what Keynes emphasized: a psychological problem --- what Keynes would call "depressed animal spirits."

.....

4) As the introduction to a 2005 Yale book with well-known economists contributing to it that was devoted to Fisher’s work put it:
“Irving fisher made seminal contributions across an astonishing spectrum of economic science: monetary policy rules, the neoclassical theory of capital and interest,, expectation inflation as the difference between real and nominal interest, the Fisher ‘ideal” index number, indexed bonds, correlation analysis, distributed lags, the “Phillips curve” [buggy: a trade-off between rates of unemployment and inflation at the margins of each, which he thought could be stable], the debt-deflation process, taxing consumption rather than income, the value of human capital and improvement in health, even the computation of general equilibrium.”
http://cowles.econ.yale.edu/~gean/art/p1198.pdf”>Click here

....

5) And yes, Fisher supported exactly your policy recommendation: quantitative easing. As he put it in his stress on liquidity hoading:

"..in the depression of 1929-32, while the volume of deposit currency in member banks was falling 21 per cent, the velocity of it was being reduced by 61 percent....a mere new supply of money, to replace what has been liquidated or hoarded, might fail to raise the price level by failing to get into circulation...a mere increase in M might prove insufficient, unless supplemented by some influence exercised directly on the moods of people to accelerate V -- that is, to convert the public from hoarding." "Booms and Depression", 1932 book.

Again, the link between effective monetary policy to fight a serious recession (or depression, with a system-wide financial meltdown) and psychological factors emerges at the center of Fisher's work.

......

6) One final point, which reflects my own puzzlement and apparently yours --- though for a different reason.

Namely? The globalizing of international finance in the last 30 years, and in particular the role of Japanese and Chinese exessive savings and hence trade surpluses of a large sort until this year . . . with their central banks' use of the $US they accumulate invested back here --- for a mixture of reasons, including safe earnings they hope (however low)on their investments, but also for neo-mercantilist reasons to keep the dollar from floating downwards in Yuan and Yen terms.

These global imbalances are far more excessive than they were in the early 1930s, at any rate once all major countries cut loose from the gold standard --- with the US first cutting loose in the firs year of FDR's presidency, then returning three years or so later at a far lower value in gold terms for the $US.

.....

Thanks again, Nick. You have a terrific web site here. My only suggestion is a web-style point: with the long length of your sentences, you might ask your web manager to narrow considerably the line-margins. And --- just a preference of my own, which you might not share --- sub-section, even if you just skip a few lines between sections. Makes it easier to run one's eye over your meaty, always-stimulating analyses.

....

Michael Gordon, AKA, the buggy professor

[Nick Rowe]

Thanks for all the comments. I'm still thinking about this one. Wondering if I have seen all sides of liquidity, or if I'm re-inventing the wheel. In many ways I am re-inventing the wheel, or at least re-labeling it "liquidity". The consumption-based CAPM recognises that you don't want assets whose returns are negatively correlated with your need for (consumption) spending. Keynes on investors' illusion that they can all sell the asset at the same time (but then most times they don't all want to sell at the same time). But I'm trying to use these existing ideas as a way of thinking about liquidity.

Don: I don't think we need loss-aversion to get the story to work (it would merely accentuate it). If you need cash when it rains, you don't want to hold an asset which falls in value when it rains.

Joe: I found the David Foot/demographics story quite plausible. But I think it operates on too long a time-scale (and is too predictable in advance) to be of much help in the current circumstances. Demographic effects on asset prices should be smooth, evolving slowly.

killben: there is risk, and there is illiquidity. Both have increased, and both could explain increased yield spreads on some assets. Most people look only at risk, but I think illiquidity is as important. Increased risk means that the variance of returns has increased. Increased illiquidity means that the correlation of returns with my wanting/needing to sell the asset has become more negative (wish I had thought of that distinction before, while writing the post). The distinction is important for policy, I think. Government policy can't obviously reduce risk, except at a cost. Government policy can increase liquidity. I need to think some more about risk vs. liquidity.

Patrick: "the more fear of illiquidity there is the more illiquidity there is and everyone ends up dead in a liquidity trap." Yes, I was starting to think along similar lines myself, when writing the post, but it looked complicated, so I left it unexplored. A positive feedback mechanism, that could make liquidity crises self-fulfilling.

Neville: thanks. I'm not sure I have got my head around the timing issues, but why couldn't the central bank increase liquidity now, in the current crisis? And why couldn't this help (if my story is correct)?

Michael: thanks very much! I've always liked Irving Fisher (especially since I discovered the Fisher diagram of savings investment and the rate of interest). What I would like to do is figure out the relationship between deleveraging and liquidity. If you are highly-levered, you want to make sure your assets are liquid. But if everyone else who holds that same asset is also highly-levered, it won't be. They will all rush to the exits at the same time.

[kevin quinn]

Nick- this is a great post. I have also been thinking a lot about liquidity. I have been teaching money and banking again recently after a long hiatus. When I get to the term structure of interest rates, I generally express my dissatifaction with the preferred habitat theory, because basis for a postive term premium is never spelled out. Is it a risk premium? No, as Meiselman pointed out long ago: it can only be risk premium if savers all have very short holding periods, since savers with long holding periods take a greater risk going short and would need a premium to do so. So ok, it's a liquidity premium, perhaps. As I put it, a saver's holding period is uncertain; if she needs to get out the range over which the long bond's price can vary in response to interest rate changes relative to the short bond makes the former less liquid. But then I say - wait a minute, didn't we just learn about banks? What do banks do? They intermediate, issuing short-term liquid liabilities to finance illiquid, long term assets. If they compete, shouldn't the "liquidity premium" be narrowed until the gap between long and short rates is simply the cost of intermediation? And then, when intermediation breaks down, as it has, wouldn't the repressed liquidity premium return?

[Nick Rowe]

Kevin: I especially appreciate your liking this post, since I know you are careful enough to read through things and spot mistakes!

I hadn't figured out the implication you just made. What you say makes sense, and confirms the theory. If the banks are in trouble, and can't borrow short and lend long as much as they used to, we should see an increase in the steepness of the yield curve as the liquidity premium reappears. And that's exactly what we see.

[reason]

I don't think you are right. Just skimming but basically I agree with Killben. Thinking this is a liquidity crisis is wrong. It is mostly a solvency crisis. Debt matters. People have been pulling off the trick for quite a while now of using leverage to push up earnings and ignoring that the same trick increases losses as well.

Personally, I got lucky - I'm sitting on a big heap of cash having sold my flat in Australia at the top of the market, and converted the earnings (also at the top of the market) into Euros. Because I saw this coming and acted in time. So my personal interest is in deflation (as long as my bank, which is also my employer doesn't go belly up). But I think the right thing for the monetary authorities to do is fight inflation - and that means printing money and spreading it around (and spreading it around is the hardest thing). Just increasing liquidity won't solve the problem. It just pushes the velocity of circulation down.

[reason]

oops
Big error - ... right thing for the monetary authorities to do is fight deflation ...