An updated Aug 2007 version of this appeared here. The 2007 article also appeared in AToL on August 24, 2007 .


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Re: Liquidity



Henry



I found your discussion of liquidity very informative and useful. Thank you
for informing us.



But I have a problem with your theoretical model. As William keeps
reminding you, it is simply wrong to regard the supply of credit money as
either given, or exogenously determined. Credit money as you more than most
know is bank deposits. As bank liabilities, deposits are simply the record
of bank assets, primarily bank loans. "LOANS CAUSE DEPOSITS".



So you cannot talk about the quantity theory (QT) in the usual (Friedman)
sense, which explicitly assumes that the supply of money is exogenously
under the control of the CB. If money is endogenous, the QT is simply an
identity, and must not be read as money "causing" anything, since money is
itself caused by other variables in the system, in this case primarily
business demand for working capital.



I would like to encourage you to try to retell your story of liquidity with
explicit recognition that the supply of credit money is determined by the
demand for bank credit.  Then we can make inroads in the liquidity problem.



Basil Moore






At 05:35 PM 6/14/01 -0400, you [Henry C. K. Liu] wrote: 

Economists refer frequently to liquidity in the abstract.  Yet in
reality, liquidity is difficult to define and even more difficult to
measure. On Wall Street, liquidity refers to the ability to buy or sell
an asset quickly and in large volume without substantially affecting the
asset's price. Shares in large blue-chip stocks like General Electric,
used to be considered liquid, a description long since rendered invalid
because of volatility. Of the several dimensions of market liquidity,
two of the most important are tightness and depth. Tightness is a
market's ability to match supply and demand at low cost (measured by
bid-ask spreads), while market depth relates to the ability of a market
to absorb large trade flows without a significant impact on prices
(approximated by volumes, quote sizes, on-the-run/off-the-run spreads
and volatilities). When market participants raise concerns about the
decline in market liquidity, they typically refer to a reduced ability
to deal without having prices move against them, that is, about reduced
market depth.


According to current market commentary, liquidity in many markets never
fully recovered from the sharp deterioration experienced during the 1998
financial crisis. However, influential market participants nevertheless
continue to express the view that liquidity conditions were, at the
current juncture, not a cause of acute concern. Moreover, it is
acknowledged that cycles in liquidity crises have been a recurring
feature of financial markets.


Commonly used indicators of market liquidity, notoriously imperfect as
measures of liquidity conditions, also suggest a rather benign picture.
While the autumn of 1998 is indeed identified as an adverse shock to the
liquidity of financial markets, liquidity indicators seem to suggest
that, with the notable exception of the US government bond market,
liquidity conditions have been broadly restored to pre-crisis levels.
However, the usual indicators typically capture only a single dimension
of market liquidity and none of    them is forward looking in nature,
making it difficult to draw any conclusions as to what liquidity
conditions might be in times of future stress.


While idiosyncratic factors might be cited as being responsible for the
perception of low liquidity in specific markets, reduced liquidity is
unlikely to be a purely conjunctural phenomenon. From a financial
stability perspective, some of the structural factors at work can be
highlighted, focusing on developments bearing on liquidity conditions at
three different levels, namely:


(i) Firms: developments at the level of the main financial firms
participating in the core financial markets;
(ii) Markets: developments in the structure and functioning of markets
themselves; and
(iii) System: developments across the global financial system as a
whole.


Such structural developments may have served to reinforce the links
between liquidity and credit risks, but also the distinction between
normal times and times of stress. Many market participants have felt
that liquidity pre-LTCM in many markets was underpriced, and that this
led financial institutions to underestimate liquidity risks ("liquidity
illusion"). Such underpricing inhibited developments that would enhance
the market's ability to retain liquidity in times of stress. There have
indeed been several occasions since the LTCM crisis when conditions in
some markets turned adverse but liquidity, which typically declined
sharply in the midst of the crisis, proved to be rather resilient.


However, some elements of recent developments,  such as financial
consolidation, the increasing use of non-government securities as
hedging and valuation benchmarks, might influence the behavior of market
participants in a way suggesting that market dynamics in times of
extreme stress may have changed significantly. This has heightened
concerns about credit risk, which can undermine market participants'
willingness to enter into transactions and thus weaken market liquidity
in a more uncertain environment. Other elements, such as
collateralisation practices and developments in risk management
policies, which should generally enhance market stability, could add
pressure in times of extreme stress.


Price is a function of liquidity which can be quite detached from normal
value. Liquidity offer a new paradigm as the key to understanding why
and how the markets move. Liquidity is consistently a reliable indicator
on which to base the timing of trading and investment decisions.


Liquidity is the key determinant of the direction of the stock market.
The aggregate capitalization of any market or market sector, whether
stocks, real estate, precious metals, etc., is a function primarily of
liquidity, with the economic value having only secondary impacts. The
total value of any market is impacted by the current liquidity trend.


Liquidity is the relationship between changes in the total trading float
of shares in the entire stock market and the change in cash available
for investment. Stock market liquidity has two components: the change in
the trading float and the change in the cash available to buy shares.
Liquidity analysis, in essence, is measuring change in the trading float
of stock and tracking the movement of cash.


Some analysts offer a daily liquidity number (Daily Liquidity Trim Tabs)
that is determined by adding US equity fund inflows, 2/3 of newly
announced cash takeovers, 1/3 of completed cash takeovers and
subtracting new offerings. Their longer term analysis of the underlying
trends in liquidity takes in account stock buybacks, insider selling and
margin debt.  Mutual Fund Trim Tabs survey over eight hundred and fifty
equity and bond funds daily. US stock market liquidity looks at flows
into equity mutual fund that are not international specific.
International equity and bond funds flow are determined separately.
Trim Tabs Market Capitalization Index measures the market value for all
NYSE, NASDAQ and AMEX stocks. The AMEX is included but not listed. Trim
Tabs Market Cap Index does not include ADR's.


Liquidity analysis starts with the overall economy's cash flow. The best
way of watching US cash flow is daily and month income tax collections.
Higher income tax collections means higher incomes.


The conventional "value" paradigm says that the overall market
capitalization is a function of the growth of aggregate cash flow of all
stocks, basically, that the stock market discounts future earnings. This
has never worked in reality. Market cap (price) is a always function of
liquidity.


The conventional value paradigm is unable to explain why the market
capitalization of all US stocks grew from $5.3 trillion at the end of
1994 to $17.7 trillion at the end of 1999, generating a geometric
increase in price earnings ratios and the like. Liquidity analysis
provides a simple answer. Between the end of 1994 and the end of 1997
the trading float of shares shrank, and from early 1998 through the end
of 1999 the trading float was unchanged. Over those same five years the
amount of money looking to buy that shrinking or stagnant pool of shares
kept growing. The result was that market cap kept rising regardless of
economic value. The end result was a stock market up over three times in
five years.  It is a clear evidence of the Quantity Theory of Money at
work.


Money flows from buyers to sellers. If the buyers retired the shares
purchased and the sellers - mostly portfolio managers - had to replace
their holdings in a smaller float, that adds liquidity. If the sellers
vend newly printed shares and used the cash for anything other than
buying other shares, that reduces liquidity.


Historically, float change (the number of shares outstanding) is the
best leading indicator of future market direction. The float shrinks via
stock buybacks and cash takeovers of public companies. The float grows
through new public offerings of stock where the proceeds go to the
company - meaning the money is not reinvested in shares. The float also
grows via insider selling of previously unregistered shares, known as
#144 sales, and when stock options are exercised and sold. When insiders
exercise and then sell an option, the company takes back the exercised
price and withholds estimated capital gains taxes. Of the remaining
maybe 50% of the sales price, no more than half is reinvested in stocks,
or at most 25% of the sales price.


While there is no cash in the stock market, there is cash sitting in the
checking accounts of stock market intermediaries. Daily mutual funds
flow of equity and bond funds are closely monitored by market
participants. Yet the best leading indicators of future stock market
performance are the actions of corporate investors. When corporate
investors are net buyers of their own and other public company shares,
the overall market sooner or later goes up. Similarly, when corporate
investors are net sellers, stocks go down. Mutual fund flows, while
large in size, are of less value as a leading indicator. Recent studies
have shown that flow is a coincident indicator. That means liquidity
changes in the same direction as the market does. Knowing which way the
flow will be going is often the key to determining short term swings in
the direction of the market.


Therefore, if one knows where liquidity is headed, one knows where the
market is headed. With regard to this, our liquidity analysis has
consistently proven to be a reliable indicator on which to base the
timing of trading and investment decisions; the key to understanding why
and how the markets move.


Liquidity determines how strongly news will affect stock prices.
Positive liquidity can spur the market significantly higher when other
indicators are positive and cushion the fall when those indicators are
negative. Conversely, negative liquidity can dampen the effect of good
news. Liquidity almost always stays in step with the market and visa
versa.


For the economy as a whole, the lower the present rate of interest, the
larger, ceteris paribus, would be a future rise, the larger the expected
capital loss on securities, and the higher, therefore, the preference
for liquid cash balances. As an extreme, though unlikely possibility,
Keynes envisaged the case in which even the smallest decline in interest
rates would produce a sizable switch into cash balances, which would
make the demand curve for cash balances virtually horizontal. This
limiting case became popular among Keynesians as the liquidity trap.  In
his two-asset world of cash and government bonds (the latter that proxy
a typical government security for which the central bank can influence
the rate of interest), Keynes argues that a liquidity trap would arise
if market participants believed that interest rates had bottomed out at
a "critical" interest rate level, and that rates should subsequently
rise, leading to capital losses on bond holdings.  The inelasticity of
interest rate expectations at a critical rate would imply that the
demand for  money would become  highly or perfectly elastic at this
point (implying both a horizontal money-demand function and LM -
liquidity preference/money supply - curve).  The monetary authority,
then, would not be able to reduce interest rates below the critical
rate, as any subsequent monetary expansion would lead investors to
increase their demand for liquidity and become net sellers of government
bonds. Money-demand  growth, then, should accelerate when interest rates
reach the critical level.


Keynes argued that there were three reasons why people hold money. They
hold cash for
transactions purposes, which is what the quantity theory had always
said. They also hold money for
precautionary reasons, so that in an emergency they would have a ready
source of funds. Finally, they
hold money for speculative purposes. The speculative motive arose from
the effects of interest rates on
the price of bonds. When interest rates rise, the price of bonds falls.
Thus when people think interest
rates are unusually low, they would prefer to hold their assets in the
form of money. If they invested in
bonds and the interest rate rose, they would suffer a loss. Hence the
amount of money people would
want to hold should be inversely related to the rate of interest. People
will want to hold more money
(liquidity) when interest rates are low than when they are higher.


Keynes' introduction of the interest rate into the demand for money has
survived in modern finance, but not for the reasons he gave. Keynes was
thinking in terms of a two-asset world: money (which earned no interest
but which was liquid and had no danger of a capital loss), and bonds
(which earned interest but which were not as liquid and which could
yield a capital loss). If one thinks not in terms of a two-asset world,
but in terms of the range of assets which actually exist in the current
financial world, there is no reason to hold cash balances for either
precautionary or speculative purposes. There are assets which are both
very liquid and which earn interest, such as money market accounts and
Treasury bills, and these are a better form in which to hold assets for
these purposes, not to mention all manners of options in structure
finance.


Though Keynes' explanation of why interest rates influence the demand
for money is outdated, other
explanations are sound. Money held for transactions purposes is much
like inventory which businesses
hold. Holding inventories either ties up funds on which a business could
earn interest, or uses borrowed
funds on which it must pay interest. Thus if a firm can sell $100,000 of
its inventory, it has $100,000 in
cash which it can either invest to earn interest or pay off debt on
which it must pay interest. The cost of
inventories increases as interest rates rise or as the size of
inventories increases.


However, there are also costs to holding inventories which are too low.
If inventories are too small, a
business may run out of items and lose sales. Further, if inventories
are held at low levels, the business
will need to reorder often, and there are usually costs to reordering.
Thus the business must balance
these costs which rise as inventories increase with the other costs
which fall as inventories increase. The
problem can be solved elegantly using calculus, but you should be able
to see intuitively that a rise in
interest rates will decrease the optimal size of inventories, and a rise
in the cost of reordering will
increase the optimal size.  Modern management has introduced
just-in-time inventory which renders this argument mute.


When people hold cash balances, they may no longer hold their assets in
a form that earns no interest, yet interest rates does generally tend to
increase with less liquidity. If interest rates rise on non-money assets
relative to money, the cost of holding money in terms of interest
foregone rises, and one would expect people to try to economize on cash.
A business, for example, could shift money from checking accounts into
t-bills, or resort to loans instead of selling assets with high future
value. It would be worthwhile to make more transactions into and out of
interest-bearing assets to take advantage of the higher interest rates.
When interest rates are very low, these transactions may not be
worthwhile, and the business may be willing to let money lie idle for
short periods in checking accounts.


In a nutshell, the argument boils down to the store-of-value function of
money. Money becomes a less
desirable way to hold wealth when interest rates on other assets rises,
and as a result people will hold
smaller cash balances. These considerations lead to a revised demand for
money function. The demand for money, or the average amount of money
people want to hold, depends positively on expected transactions and
negatively on the interest rate. The coefficient should be a negative
number because with higher interest rates people should want to hold
smaller cash balances.


To complete this part of the model, a money-supply equation and an
equilibrium condition is needed. A
simple money-supply equation is that money stock is determined outside
the system by policy. The
logical equilibrium condition is that the market for money balances is
in equilibrium when money supply equals money demand. When interest
rates are very low, people have no special reason to avoid holding idle
cash, and will hold considerable amounts. If they hold lots of cash
idle, the fixed amount of money cannot support very much spending. Lots
of idle cash means that the representative dollar is not being spent
very frequently - i.e. low velocity.


On the other hand, if interest rates are very high, holding idle cash is
costly, and people will try to keep
their cash holdings low. This means that they will spend money rapidly,
or that the velocity of money will be high. With higher interest rates
the same fixed quantity of money will support more spending than it did
when interest rates were low and people were holding idle cash balances.


The LM curve (Liquidity Preference/Money Supply) shows how much spending
some fixed amount of money will support. When interest rates are high,
money is spent rapidly and supports a lot of spending. When interest
rates are low, the money stock supports less spending.  A flattened LM
curve is  a representation of Liquidity Trap.


The addition of interest rates to the quantity theory allows fiscal
policy to have effects within the logic
of the quantity theory. If, for example, the government reduces taxes,
thereby raising its deficit, it must
borrow more. This added borrowing increases the demand for loanable
funds and the price of these
funds, which is the interest rate, should rise. The higher interest rate
makes holding idle funds more
expensive, and should result in an increased velocity of money.


Examining the way the ISLM (Investment/Saving - Liquidity
Preference/Money Supply Equilibrium)
model is constructed reveals that a change in fiscal policy alters only
equations that are used to build the IS curve, and changes in monetary
policy alters only equations used to build the LM curve. An expansionary
fiscal policy will shift the IS curve, increasing interest rates and
income. An expansionary monetary policy will shift the LM curve,
increasing income but decreasing interest rates. The way in which one
shifts these curves is exactly the same as how one shifts curves in the
model of supply and demand.


To keep the demand for money constant (which means that the velocity of
circulation remains
constant), the nominal interest rate must remain constant.


Further, the rate of inflation independently affects the demand for
money by changing its desirability as
a store of wealth. In cases of very serious inflation, such as the
German hyperinflation of 1923, people try
to spend money as quickly as possible because it is losing its value. As
a result, the velocity of money
increases. To some extent estimates of how sensitive money demand is to
interest rates may be catching
this sensitivity of money demand to inflation because rates of inflation
and interest rates move together.
A liquidity trap tend to develop in a price deflation environment.


IS curve is a function of the real interest rate; LM curve is a function
of the nominal interest rate;
IS-LM curve must be drawn with the real interest rate (nominal interest
rate - expected inflation rate)
and LM curve cannot go below the nominal interest rate = 0 (or the real
interest rate = - expected
inflation rate).


On May 15, 2001, the United States Federal Reserve Board cut Fed Funds
rate by half a percentage point. It was the fifth rate cut this year and
brought the total amount of monetary easing to 2.5 percentage points to
the current 4%.  Greenspan's decision to cut rates in half-point stages
every month in 2001, despite criticism that such actions were "too
little, too late," was constrained by concerns about inflation. With
whole sale prices rising at 3.7% annually, Greenspan is facing zero or
negative real interest rates.  Obvious excess capacity in the the Old
and New economies prevents an interet-rates induced capital spending.
The amount of nonperforming loans held by U.S. financial institutions is
on the rise. As of the
end of March, the amount of distressed loans grew roughly 10 percent
from the end of last year. There is also a huge telecom loan fiasco
unraveling. This trend continues despite interest rate cuts.  A credit
crunch is developing in which lender are having difficulty finding
qualified borrowers at prime rate. Long-term interest rates, which are
not easily affected by Fed policies has been rising. The yield on
10-year Treasury bonds, which at one time had fallen to levels around
4.5 percent, have recently risen to around 5.73 percent yesterday (June
13). This reflects the limits of credit easing and the possibility of
future inflation. This rise in long-term interest rates, coupled with
the macroeconomic slowdown and the decline in corporate earnings, forms
the backdrop against which stock prices are falling. This could also
lead to a vicious circle in which lower stock prices affect consumer
spending.


The U.S., just as Japan, appears to be falling into a liquidity trap.


Henry C.K. Liu