Alice in Liquidity Land

Lewis Carroll, author of Alice's Adventures in Wonderland, might have felt right at home in the modern financial world.

Not only would he have found plenty of odd or outlandish individuals to model his characters on, but he would also have been able to witness regular bouts of bizarre behavior that would have provided ample storyline fodder for a collection of children's fantasies. Moreover, Carroll would likely have been intrigued by the through-the-looking-glass perspective of today's Wall Street, where bad usually gets spun as pretty good, and good is seen as nothing less than great.

Odds are, however, that the English mathematician and reverend would have understood, like author and Yale economics professor Robert J. Shiller, writing in "That Hazy, Crazy Bubbly Feel of Liquidity," that there really is a difference between fantasy and reality.

We increasingly hear that "the world is awash with liquidity," and that this justifies expecting asset prices to continue rising. But what does such liquidity mean, and is there really reason to expect that it will sustain further increases in stock and real estate prices?

Liquid assets are assets that resemble cash, because they can easily be converted into cash and used to buy other assets. The idea seems to be that there are a lot of liquid assets lying around, and that they are being used to get money to bid up the prices of stocks, housing, land, art, etc.

That theory sounds as general and fundamental as the theory that global warming is melting glaciers and raising sea levels around the world. Rising sea levels would explain many geological and economic events. Is rising financial liquidity a similar force? What is this theory anyway?

Traditionally, "awash with liquidity" would suggest that the world's central banks are expanding the money supply too much, causing too much money to chase too few goods. But if that were the problem, one would cause all prices — including, say, clothing and haircuts — to rise. That is what the Federal Reserve Chairman Arthur Burns meant when he said the United States was "awash with liquidity" in 1971, a period when the concern was general inflation.

But the recent popular use of the term "awash with liquidity" dates to 2005, a time when many central banks were tightening monetary policy. In the U.S., the Fed was sharply raising rates. Central banks worldwide clearly have been behaving quite responsibly with regard to general inflation since 2005. According to the International Monetary Fund, world inflation, as measured by consumer price indexes, has generally been declining since 2005, and has picked up only slightly in 2007.

So it is something of a puzzle why people started using the term so much in 2005. It may have had something to do with the near-total lack of response of long-term interest rates to monetary tightening. If central banks are tightening and long-term rates aren't rising, one needs some explanation. Liquidity is just a nice-sounding word to interpret this phenomenon.

Another interpretation is that people are saving a great deal, and that all this money is chasing investment assets, bidding up prices. Current Fed Chairman Ben Bernanke raised this idea a few years ago, alleging a world "saving glut."

But, once again, the data do not bear this out. The IMF's world saving rate has maintained a fairly consistent downward trend since the early 1970s, and while it has picked up since 2002, it is still well below the peak levels attained in the previous three decades. True, savings rates in emerging markets and oil-rich countries have been increasing since 1970, and especially in the last few years, but this has been offset by declining saving rates in advanced countries.

Another interpretation is that "awash with liquidity" merely means that interest rates are low. But interest rates have been increasing around the world since 2003. Hardly anyone was saying the world was "awash with liquidity" in 2003. The use of the term has grown in parallel with rising, not falling, interest rates.

Yet another theory is that changes in our ways of handling risk have reduced risk premiums. The growth of sophistication in the financial markets has allowed risks to be sliced and diced and spread further than ever before. Indeed, the much-vaunted market for collateralized debt obligations, which divides risks into tranches and places different risk levels in different places according to the willingness to accept them, has plausibly played a role in boosting asset prices. But this is really a theory about risk management for certain kinds of products, not "liquidity" per se.

Hyun Song Shin of Princeton University proposed a theory of excess liquidity in a paper with Tobias Adrian that he presented last month at the Bank for International Settlements in Brunnen, Switzerland. He says that it merely reflects a feedback mechanism that is always present: Any initial upward shock to asset prices strengthens the balance sheets of financial institutions, so in response they borrow more and bid up prices even more.

But if that is what the term "awash with liquidity" means, then its widespread use today is simply a reflection of the high asset prices that we already have. It could even be called an approximate synonym for "bubbly."

The term "awash with liquidity" was last in vogue just before the U.S. stock market crash of Oct. 19, 1987, the biggest one-day price drop in world history. The reasons for that crash are complex, but, as I discovered in my questionnaire survey a week later, it would appear that people ultimately did not trust the market's level. As a result, they were interested in strategies — such as the portfolio insurance strategies that were popular at the time — that would allow them to exit the market fast.

The term "awash with liquidity" was also used often in 1999 and 2000, just before the major peak in the stock market. So its popular use seems not to reflect anything we can put our finger on, but instead a general feeling that markets are bubbly and a lack of confidence in their levels. Under this interpretation, the term's popularity is a source of concern: It may indicate a market psychology that could lead to downward volatility in prices.

Hmmm, "downward volatility in prices." Is that anything like Alice falling into the rabbit hole?

Comments

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I believe that the term liquidity is nothing more than a euphanism for credit. Thus, the term "awash with liquidity" refers to very easy credit. This is vastly different from being awash with money or savings which has been squadered, because in the case of squadered credit a debt is required to be repaid with high interest rates.

[Michael Hodges]

Michael,
Considering recent turmoil in debt markets, last week I re-read much of your book and send along my congratulations. You hit a lot of 'nails on the head' regarding unprecedented debt in a way most people should easily understand these serious threats.

Data in the Grandfather Economic Report series backs-up much of your book.

Unfortunately, many innocent citizens who are unaware of your book and the implications of that which you write may more and more realize big-time principal hits.

America faces most serious economic challenges. Thanks for your excellent contribution.