More thoughts on the relationship between money, prices and liquidity (not to forget the incredible Mr Beckwith)

As this is another post on “liquidity”, it is only fitting we should pause for a minute to reflect on the passing of Ray Beckwith, who died on Nov 7, 2012 at the age of 100.  Ray Beckwith was a quiet achiever –  you have probably never heard of him, but without this great scientific mind, the good wine that we take for granted would not exist. He was the science behind the global wine industry. You can read a bit about him here, while you pour yourself a glass of your favourite red.

Back to the topic of money and liquidity. This post gets at a question: why can we experience a contraction in global liquidity and real GDP without deflation?  It takes a bit to get to the answer, so be patient.

Let’s try a few thought experiments. First one is simple. Suppose to start with that we live in a world where the only money was central bank money.  There are two countries in the world: call them Australia and Canada (though this is all fictional/hypothetical).  The same quantity of money circulates in both countries. Australia, though, is “drier” than Canada in the sense that money is not quite as liquid down under in Australia as up-over in Canada. Bob Clower’s axiom that “money buys goods and goods buy money” doesn’t quite hold there – money isn’t quite as liquid as it is in Canada where money *is* the medium of exchange.  Hypothetically, you could imagine why this might be the case: in Australia population density might be low – people living in small isolated towns;  not knowing for sure what a dollar is worth in another town, but being fairly comfortable about what a pound of salt case of beer is worth. In Canada, everyone lives in Toronto or Montreal, and they know exactly what a dollar is worth; they might lug a “two-four” around, but that’s just in case one of their mates happens to be watching the hockey and invites them in.

This might seem counter intuitive, but because money is less valuable (its marginal utility is lower) in Australia, the general level of prices in terms of money is higher. Basically, in Australia, money is a “hot potato”; it’s not useful for much, so as soon as you get it, you try and fob it off to someone else by buying whatever you can, so prices, in terms of money, are higher in Australia.  In Canada, you hold on to it, because it’s readily accepted as a means of payment (including for beer – and you never know when you might get invited over to watch the hockey).

In addition, despite money having the hot potato element to it, there are probably fewer transactions happening in Australia because people are relying more on barter, and the transactions that they do make are less efficient because they don’t get what they really want for their efforts (you can read about this happening in Greece).  Since the economy is founded on the gains from trade, the relative illiquidity of money also reduces the gross domestic product in our hypothetical Australia compared to our hypothetical Canada (and in our real world Greece too).

Now suppose that liquidity suddenly improved in Australia – the internet is introduced and people in different towns now know exactly what money is worth (in terms of goods) all over Australia. The price level would now fall because money has become more valuable.  Essentially, the increase in liquidity of money makes it more valuable and, given that the supply of money is fixed, it creates a shortage of cash.  At the same time the improvement in liquidity means that more people are using money to facilitate trade and productive activities, there are more monetary transactions and real GDP is higher.  This may produce a network effect that further enhances the liquidity of money (presumably at the expense of salt beer). In a way, it’s like Australia had a sudden a dramatic fall in inflation. Indeed, arguably monetary liquidity and inflation are pretty similar things.

But that is not all.  The improvement in monetary liquidity is likely to increase the liquidity of “private” financial assets too and this means that the stock of non-central bank money-like assets will endogenously expand in response to the increase in money demand.  For example, suppose a young Aussie bloke wanted to buy a house, but lacked the cash to do it, so he issued some IOUs to his family and friends to raise the cash. Those IOU’s are financial assets and when money becomes more liquid, it not only makes it easier to buy and sell not only goods and services, but IOUs too – even if just from one family member to another. To the extent that those IOUs can be more readily traded, they could also be more readily used as a form of money (see the earlier post on liquidity here). I guess we could call these IOUs a primitive form of mortgage backed securities.

You can start to extend the analogy further. Typically, most of us don’t engage in day to day buying and selling of mortgage backed IOUs.  Instead we deposit cash at banks that in turn pool the funds and lend to home buyers.  In so doing, banks create liquidity.  They transform a relatively illiquid asset (a home loan) into callable cash deposits, which, because they are callable, are often treated as money.

The trouble is that in the process of creating liquidity, the bank exposes itself to the potential for a run, ‘cos depositors know that if all depositors wanted their money back at the same time, the bank wouldn’t be able to convert the mortgages to cash.  As a consequence, the more likely that a bank could suffer a run, the less liquid its deposits will be. But a run on the banking system is less likely to occur the more easily the bank could sell its mortgages on some secondary market (because then the bank could more easily cover a large withdrawal of deposits).  And that is more likely when central bank money is more liquid.

Thus, an improvement in monetary liquidity broadens the range of financial assets that are money like and helps to increase the money supply.  Indeed, when there is an increase in the demand for money created by an improvement in the liquidity of central bank money (as described in the first example above), it is likely that the increase money demand could be satisfied through the creation of bank deposits, which itself is made possible because the improvement in monetary liquidity makes other financial assets more liquid too.

What does all this mean?  Well it means that when certain events affect the monetary environment and change liquidity conditions, the range of money like assets adjusts endogenously.  It is not clear whether it more than compensates for the change in money demand that changing liquidity implies or not.  But it happens.  This means that there may not be a dramatic effect on the price level from a change in monetary liquidity. However, as our hypothetical Australian example (or the real world example of Greece) illustrates, although prices might not change, real GDP will.  That is why we can experience a contraction in global liquidity and real GDP without necessarily experiencing deflation.

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