Torrens has been trying to write this post for a week or more. It’s about the public good nature of liquidity. He remembers learning about this sometime, but it’s one of those things that he can’t exactly remember where he read it, or who taught it to him. So he won’t attribute it to anyone (but his old professor TK might have had something to do with it). Regardless, it is likely many people have had the same thought (just google the title of this post).
This is a bit dense — apologies in advance. Some thought starters to get us going. On money first. Money is an asset that can be readily exchanged for goods and services as well as other financial assets. There are two types of money: central bank money (aka outside money or public money) and private money (bank deposits are a good example). Money is quantifiable – it makes sense to talk about the quantity of money. Also money (whether private or public) is just an asset that can be bought or sold in markets – money has a price.
Now liquidity. An asset’s liquidity is related to the moneyness of the asset – the more like central bank money an asset is the more liquid the asset is. That is, the more readily the asset can be exchanged for goods and services or other financial assets, the more liquid it is. For this reason, an increase in the liquidity of privately created financial assets is effectively an increase the supply of inside money because an increase in overall market liquidity broadens the range of assets that can be used as money.
That being said, liquidity is a quality measure rather than a quantity measure. The liquidity of an asset is characteristic of the asset that is derived from the environment in which it trades – the more people that trade in a financial asset, or the more actively traded an asset is, the more liquid it becomes. In this sense, liquidity is a something of a public good. The market environment (or market condition) affects all traders, whether they like it or not. It’s hard to exclude people from a liquid market. And market liquidity is mostly non-rivalrous – one person’s use of the market doesn’t detract from the ability of another to use it. That being said, a person’s use of the market might improve market liquidity because of the well-known networking effect; so not using it can detract from the quality of the market in the same way that polluters can detract from the quality of the natural environment. Thus, in a way market liquidity could also be considered to be a common property good (like a fishery).
Unlike other public goods, market liquidity is typically privately provided – it results from the actions of those who trade in financial assets, including money. But because there is generally no way of pricing market liquidity (I can’t generally prevent people from using a market in order to charge them for it, and even if I did it should generally be free or perhaps even subsidised), market liquidity is unlikely to be optimally provided. People can pay a premium for an asset that is liquid, but that does little to help create more liquidity, it just affects the price of the assets in the market. Even if it did encourage more people to create that type of asset, the creator of the asset doesn’t realise to full benefit of his actions, he only shares in it. Similarly, unlike most commons, financial market liquidity is not over-exploited, but you could think of a situation in which a market participant might erode market liquidity without considering the consequences for others (e.g. a bank that fails to meet hid obligations vis-à-vis another bank).
Generally speaking, public goods are underprovided and common property goods are overused. It is not clear that market liquidity is necessarily under provided by private participants, but what is clear is that some the market for some financial assets wouldn’t be liquid if it wasn’t for the efforts of the central bank. Most importantly, by acting as a central clearing house for bank deposits, the central bank ensures that bank deposits can always be treated like money – it increases people’s willingness to use bank deposits to buy goods and services and other financial assets. The Euro Area Target 2 system is a great example. If it wasn’t for the remarkable eurozone clearing house, euro area bank liquidity would have completely dried up by now, and banks (and the common currency area) would have gone bust because no one would accept deposits at Spanish or Greek banks as money.
What about the relationship between monetary policy in the traditional sense and liquidity? Suppose that monetary policy is done the old fashioned (or is that the new fashioned) way and the central bank goes out and buys government bonds in exchange for money it “printed” (so called open market operations). Some of that money gets held as cash and some gets spent on other financial assets (and goods). The price of those other financial assets goes up, which makes it more attractive for people to issue those assets. So the supply of the assets might rise in response to the extra demand (and higher price) for them. By inducing more participants into the market, the open market operation may trigger an increase in market liquidity.
Furthermore, changes in liquidity in one market quite likely affect liquidity in another. For example, if interbank liquidity was to improve then markets that depend on the interbank market will also experience an improvement in liquidity. This reflects the fact that counterparties in various transactions are often dealing in different instruments – bond dealers trading with currency dealers and currency dealers with bond dealers. So there is a “strategic complementarity” between participants in the two markets. An improvement in the liquidity of one market tends to make it easier for dealers to deal in the other. On the other hand, some markets might be substitutes for one another. In which case, an improvement in liquidity in one market might draw traders away from another, with the improvement in market liquidity having a self-reinforcing effect in the former market and a liquidity eroding effect in the latter. When the markets are complementary and something boosts liquidity in one market, it will act as if there was an increase in the supply of money in both markets. If the markets are substitutes, the improvement in liquidity in the first market will have an expansionary effect on the effective money supply in the first market and a contractionary effect in the second.
Taking into account the public good nature and externalities/complementarities associated with liquidity, it will not be “optimally” supplied and it is not surprising, therefore, that central banks intervene to affect liquidity conditions (especially when a negative shock erodes liquidity). But despite good intentions, it is not clear that central bank action will provide the right amount of liquidity either.
First, the central bank’s primary monetary policy objective is to achieve an inflation target of some sort, liquidity management is subservient to that and it is not obvious to TH that such an objective would also produce the optimal amount of liquidity (but it might).
Second, even if the central bank produced the optimal amount of overall liquidity for its own citizens, would it be optimal for the variety of local markets or for foreign market (since most financial markets are not bound by borders)? Probably not, but who knows, maybe. It’s easy to think of some examples – a central bank might set monetary policy just right to keep inflation low, but there may be excessive liquidity in subprime mortgage markets that causes a housing bubble and a shortage of liquidity in markets for markets for public-private infrastructure financing. Or, the amount of liquidity being created by the US Federal Reserve right for the US but not for the rest of the world considering that the big US bank operate in other markets (and foreign banks operate in the US).
Last main point here. It seems plausible that in some instances public policy may exploit the common property nature of liquidity. Establishing liquid financial markets requires considerable effort – it requires that contracts can be readily written and honoured, governance and accountability mechanisms, trading facilities, good financial regulation and supervision and so on. These are costly, and it can be tempting to not bother – even if it means issuing financial instruments in other markets that results in a mis-match between the needs of the parties involved. Policy makers are also free-ride on market liquidity when they make decisions (or fail to make decisions) that erode confidence and liquidity.
So let’s sum up what has been a dense post. There is money – both inside (private) and outside (central bank) money – that can be counted and measured. There is liquidity which results from the quality of the environment in which financial assets are traded – this is a market characteristic that is difficult to measure. If the environment is sufficiently good (i.e. if market liquidity is good) then the financial asset could become money too (as bank deposits are). Improvements in market liquidity can create more money, but more money does not necessarily create more liquidity, but it can. And, generally speaking there is probably not an optimal amount of liquidity being produced either by public or private actions.
So you have read this far. We’ll come back to the issue of liquidity again, I am sure, but before wrapping this one up, TH wanted to show you this chart. It shows how employment in the financial services sector has changed across a variety of countries in Europe. Specifically it shows, for each year the change in employment in the financial sector compared with four years earlier. This 4 year moving window was chosen so that the last observation shows the change in employment today compared with before the crisis. TH reckons that this shows how financial markets in some jurisdictions might be thought of as more liquid than in others. Losing jobs in the financial sector, means that financial instruments aren’t being actively traded in that country, increasing employment means more transactions and more liquidity. Interestingly, in Europe, France (green) seems to be the big winner – it didn’t batter an eyelid, while Germany (large purple bars), which was struggling with its landesbanks before the crisis, seems to have stemmed the tide. But apart from that — the financial services sector in Europe has been doing just what you would expect — shedding jobs.
European Financial Services Employment (change over last 4 years)
Since writing this, TH sees that Nick Rowe over at the Canadian Worthwhile Initiative has a post on liquidity and velocity, which is closely related to this one. Check it out