Steve Waldman at Interfludity did me the high compliment of picking up on an issue that is important to me and running with it:
Yves Smith packs a powerful insight into an unassuming sentence:
Liquidity is not a virtue in and of itself unless it produces a benefit to the real economy.
Liquidity is often said to be the great lubricant of financial markets. Let’s go with that metaphor for a moment. Yeah, baby, liquidity. It’s high performance motor oil that turns hard metal to smooth silk and keeps the engine of capitalism firing on all cylinders! Pop the hood and pour that stuff in. Rub it onto the gears and axles, so nothing ever squeals, pops, or (God forbid) grinds to a halt. Slather it all over the tires, so that no friction comes between our purring metal machine and the sweet American road.
Ummm, wait a minute… Putting lubricant on the tires might not be such a great idea after all. Friction is precisely what tires need to do their jobs. Throw a lot of oil on the tires and, well, something bad might happen.
Similarly, in financial markets, we want liquidity at some times and in some places. But there are times and places where we want, even need (gasp!) illiquidity!
Illiquidity. That word is so ugly. What might be another word for the same phenomenon? How about “commitment”? When a person invests in something that is not very liquid, they are committed. They are necessarily betting on its fundamental value. Liquid securities can be bought or sold as a trend or a trade or a play for a greater fool. But if the thing you are buying can only be sold with a big haircut, you’d better hope for a really gigantic fool if you have no confidence in its underlying value. (Clever managers did find ways around this problem, but let’s put principal/agent issues aside for the moment.) When financial markets are too liquid, everything looks like cash. Superfluous distinctions — like the economic meaning of the assets bought or sold — fall by the wayside. Sure, investors always prefer liquidity to illiquidity. An option to buy or sell quickly and cheaply is preferable to an option to buy or sell slowly and with large transaction costs. But just because investors like something doesn’t mean that it’s good. Investors like rainbows and ice cream and free money from taxpayers. But the rest of us prefer that investors make serious, informed decisions about what is and isn’t of value, and that they be paid for evaluating and actually bearing risk, rather than artfully shifting it (or whining when it cannot be shifted, because omigawd-there-is-no-liquidity!). Of course there is a balance here, commitment is one thing but a ball and chain is another, if assets become too hard to buy or sell, the costs of financing genuinely useful enterprises would increase until even good risks are not borne at all. It’s not that liquidity is a bad thing. It’s a good thing of which there can too much.
Waldman teases out the problem further, positing that there may be an “accurate” level of liquidity given uncertainty in future asset values. Felix Salmon objected to that idea, noting that tech stocks, with highly uncertain payoffs, nevertheless are highly liquid, and vice versa, some paper that really does appear to deserve its AAA rating, but simply doesn’t trade (that isn’t that unusual; certain Treasury issues, sold almost entirely to the Japanese, don’t have much of a functioning secondary market).
I had originally started noodling the problem from a more mundane perspective. There is a bias in policy (at least as far as the stock markets are concerned) towards promoting greater liquidity. That was the reason for decimalizing stock prices rather than having them quoted in eights, for instance.
I’ve long wondered where this belief that more liquidity is good comes from. Perhaps it is a bleed-over from economic theory, where the models often assume an absence of transaction costs. Per Waldman, they are treated as frictional costs, and friction is assumed to be bad.
Yet in real life, those frictional costs may lead to positive externalities. Yes, it’s no doubt more efficient to order books from Amazon, but there is something to be said for going to a local bookstore if the owner is an enthusiast and might occasionally steer you to works that were outside your taste. Those bookstores are sadly a dying breed due to the lack of enough literate staff and buyers who will pay more for a personal touch.
But in the equity markets, it may be easier to make a case for the hidden costs of perhaps too much ease of trading. The usual scapegoat for Corporate America’s short-termism is options-based executive pay. But another culprit is the lack of long-term shareholders. I should verify this independently, but a McKinsey director told me not long ago that the average NYSE stock is held seven months, down from eleven months around 2000. No wonder CEOs feel they can pay themselves whatever they want to. They truly aren’t beholden to anyone. Transient stockholders deserve no loyalty, but the loyal owners wind up being comparatively few in number (I’d love to see a chart showing the full distribution).
And as Waldman said, high transaction or other fricitional costs make one think harder about taking a risk. This is a point Tanta has regarding both mortgage origination and loan assessment. The traditional, more intrusive, “prove it to me” style of lending reminded borrowers that signing a mortgage was indeed a big deal and they should consider it carefully. The longer process also had the effect of creating an enforced cooling off period. Tanta has also repeatedly questioned the virtues of highly automated loan scoring, particularly as some tools used for communication with borrowers (primarily FICO) then became important in loan pricing, which in turn affected the origination process (although she regards that as less pernicious than the impact on pricing). As she noted:
Perhaps speed and efficiency are more “expensive” than we thought? Perhaps you don’t have to be an outright Luddite to conclude that, maybe, we should give this tech fetish another thought? I have observed before now that I very often think we fail to consider certain kinds of tech in the mortgage business at its “true cost,” and that once you do that, you often find the vaunted cost savings and productivity increases kind of evaporating on you when your business adapts, like the Borg does, to whatever high-tech weapon you can fire at it. But I am known as an unassimilated thinker.
I may be as well, and consider that to be a good thing.
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This is an excellent post. It might be said that the new name for bailout is liquidity or given how long this has gone on maybe it’s the other way round. The whole point of the liquidity mania is to make all assets equivalent to cash. The consequence of this is cognitive failure. Should we evaluate risks in dollar, or perhaps, yen terms? What the hell why not evaluate it in Yahoo or even AMR terms. People talk about moral hazard but the great risk in the liquidity mania is cognitive hazard as market places are overwhelmed by monetary noise.
If you compress a petroleum based lubricant, it ignites; if you rapidly disperse it, it easily explodes. Sound familiar, hey?
To me, much of the distorted thinking regarding liquidity has its root in the tortuous notion that there is no distinction between price and value. If transactions are based on accurately assessed and stable values, than liquidity is a good, and one should presume that said liquidity in executing transactions closely tracks the inherent risk of the assets and terms involved. But if liquidity is based on price, stability and risk are inherently obscured—and too easily and too often forgotten altogether.
Consider our present situation: government intervention in the financial markets has indeed provided liquidity, but with valuation discovery, counterparty risk, and systemic stability all still deeply obsured we have little in the way of transactions. Soooo . . . valuation does appear to matter after all, what?
I’ll repeat this because it has been so often dismissed and remains obscured: Where valuation is transparent, liquidity—high or low—corresponds directly and closely to it. That kind or liquidity, but _only_ that kind is good. HIghly liquid but value-obscured assets or transactions, are, well, vaporous and combustible, as we now see.
“Liquidity”‘s virtue appears to be that it is a good slippery word.
The whole point of the liquidity mania is to make all assets equivalent to cash. The consequence of this is cognitive failure. Should we evaluate risks in dollar, or perhaps, yen terms?
Even more ironically, the long term effect of attempting to use excessive liquidity to transmorgify risky illiquid assets into the equivalent of cash has been to transfer risk from the former to the latter. We started out trying to make buying houses as safe as holding dollars, and ended up making holding dollars as risky as buying a house.
Perhaps a lesson to be learned here is that liquidity acts as an efficient conductor of risk. It doesn’t make risk go away, but moves it more quickly from one investment sector to another.
From a complex systems theory standpoint, this is exactly what you would do if you wanted to take a stable system and destabilize it.
Anon of 2:56 PM,
You complex systems comment is an important observation. Can you elaborate? Thanks.
Yves,
One of the things that helps to enable non-linear behavior in a complex system is promiscuity of information (i.e., feedback loops but in a more generalized sense) across a wide scope of the system.
One way you can attempt to stabilize a complex system through suppressing its non-linear behavior is to divide it up into little boxes and use them to compartmentalize information so signals cannot easily propagate quickly across the entire system.
This principle has been recognized in the design of software systems for several decades now, and is also a design principle recognizable in many other systems both natural and artificial (c.f. biology, architecture) which are very robust with regard to exogenous shocks. Stable systems tend to be built from structural heirarchies which do not share much information across structural boundaries, either laterally or vertically. That is why you don’t die from a heart attack when you stub your toe, your house doesn’t collapse when you break a window, and if your computer crashes it doesn’t take down the entire internet with it.
Glass-Steagall is a good example of this idea put into practice. If you use regulatory firewalls to define distinct investment sectors and impose significant transaction costs at their boundary that will help to reduce the speed and amplitude of signals which will propagate from one sector to another, so a collapse in one of them will be less likely casue severe problems in the others.
It worries me that we’ve torn down most of these barriers in the last several decades in the name of arbitrage, forgetting that the price we paid for them in inefficiency was a form of insurance against the risk of systemic collapse. This is exactly what I would do if I wanted to take a more or less stable, semi-complex system and drive it in the direction of greater non-linearity.
I think this was to some degree inevitable – it is a symptom of the decay and loss of trans-generational memories from our last great systemic shock in the 1930s. I suspect that something like this is bound to happen every 3-4 generations as we unlearn the lessons our grandparents and great-grandparents learned to their cost.
-Anon2:56
The problem with you, Yves, is that you are thinking too rationally, and have a realistic view of how the world works. According to Marc Faber, being that way has a tendency to become clinically depressed. On the other hand, the chronically optimistic lot tends to have a happier life, even though they are delusional.
Liquidity always makes me think of The Hoover Dam or Grand Coulee, where future liquidity is stored for future energy demand. In order for the dam to work, the structure has to be engineered for stability, strength and to hold the flood back. The dam metaphor works well for banks today that are full of holes and drained of liquidity because of poor controls, poor engineering, poor oversight and a lack of fiduciary responsibility, i.e, it’s as if this round of managers turned a blind eye to responsibility and opened the floodgates and left everything up to the next shift.
This type of reckless behavior has resulted in chaos, wrecked the dam, destroyed crops and obviously reduced the value of the dam, while increasing the cost of liquidity!
These people should be going to federal prison!
Google Tobin Tax. Although first proposed for currency trading, there’s no reason to think it would not work similarly for other asset markets, since the goal is the same in both cases: to throw some sand in the gears, slow things down. It might be a bit harder to enforce, since currency is presumably more easily tracked, but