Through the Looking Glass: 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

[William Feader:]

I didn't bother reading the entire article and I have a lot of respect for Posner, however, having sided with the bears during the last 14 months cost me a 30% increase in my investments. That's the amount that the Canadian TSX index has increased since all the hulla-ballo started about 'shaky' financial conditions and excess liquidity. I have no doubt that at some time in the not too distant future interest rates may rise to 6 or 7% and cause a sharp drop in the North American indexes, however, one could also make a reasonable argument that (1) the increased liquidity is first and foremost a response to the real rate of inflation in the US (some put this figure as high as 12%), and (2) the US is actually in a process of 'capitalizing' emerging markets such as Chindia and countries in South America since those locations are still using US currency.

Add to that the fact that corporate profits have been growing in the double digits for years and it looks like the economy is doing a swan dive rather than a belly flop and I have to wonder if the so called 'excess liquidity' is actually excessive at all?

2007 Jul 20 09:26 AM

[David44:]

I enjoyed the article, but would like to suggest another meaning for "awash with liquidity". I think it might refer to the huge amount of dollars looking to be invested from Asia (trade surpluses) and the OPEC countries (oil revenues). Whether this constitutes the potential for a bubble, I am not sure. I consider it more of a growth in the US$ as the preferred currency for savings storage. If that changes, we might look back on it as a bubble. However, it is by no means clear to me that it needs to change anytime soon (i.e. in the next few years).

2007 Jul 20 06:21 PM

[rolfnorfolk:]

Bears can make a profit. I listened to the contrarians and set up a small regular premium mutual fund-based commodity investment for my wife, between Feb 2005 and October 2006. (Small because I'm British - they don't let us keep much of our money here). Annualized average return since commencement, after charges: 33%; since November 2006 even faster: 45% annualized. Wish I had more to put in, but I've had to pay my tax bill today. A bear in one sense is a bull in another.

If there's a market shakeout, I would expect this investment not to drop as much, because it's in tangibles with intrinsic value; and if (as many expect) helicopters start to drop dollars to compensate for recession, I would then expect it to soar.

Read my blog "Bearwatch" at theylaughedatnoah.blog... - a financial digest following bearish experts like Michael Panzner, Marc Faber, Jim Puplava etc.

2007 Jul 21 06:37 AM