This post first appeared on May 6, 2008
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.