At the end of this post, you’ll find an embedded a lively, thought-provoking speech by economist and Financial Times writer Jphn Kay made at a Bank of International Settlements conference last month. Kay discussed how the claims made by people in the financial services industry, that it was special, in terms of its role in the economy and its mode of operation, are made by just about every industry and don’t hold up to scrutiny.
There were two parts I particularly liked. One was when Kay debunked the notion that financiers play an oh-so-importnat role in allocating capital to its highest and best use. We’ll put aside the fact that if that were true, why did we have such a spectacular blowup in 2008 and why are central bankers working so hard to intervene in that process?
Kay explains that real-economy investment decisions are made by real economy players, like major corporations who make capital budgeting decisions. And the overwhelming source of investment funding for companies is retained earnings, not external funding. Similarly, we’ve pointed out that the role of venture capital in start ups is deminimus. Only 1% of new companies get funding form VCs. Even with among the highly successful enterprrises that these investors target, only a minority get funding from them. Professor Amar Bhide has found that only 25% of the Inc 500 had brought in venture capitalists. And some of those came in shortly before an IPO, with their main role thus validating the company to help it get access to better underwriters rather than playing a critical role in its growth.
Another good discussion was on a pet topic, how Big Finance makes a great deal of fuss about the importance of liquidity and goes all hair-a-fire if liquidity falls. We’re long been of the view that the ability to sell large amounts of securities on a hair-trigger is a very recent convenience that didn’t impede successful investing in the stone ages of the 1970s and 1980s.
As Kay put it:
A paradox of financialisation is that the need for an active share market has diminished at the same time as the volume of trading has grown exponentially….
The word liquidity is widely – almost obsessively – used in financial markets, but often without any precise or particular meaning. A casual search of investment dictionaries and encyclopaedias for definitions of liquidity will reveal as many definitions as sources.
The concept of liquidity I will use draws on a homely analogy. In the Edinburgh of 50 years ago, fresh milk was delivered daily. Except at Christmas. The milkman would make a double delivery on Christmas Eve. My father would ask each year how the cows were persuaded to produce twice as much milk. This feeble joke was part of our family Christmas ritual.
The dairy’s problem was not, in fact, very difficult. The fresh milk was not so fresh: it had not come from the milking shed that morning. Stocks could be built up, or run down. In the days before Christmas, milk which would normally have been sent to manufacture other dairy products was diverted to household use.
At ordinary times, our demand for milk was stable. But sometimes we would have visitors and need extra milk. My mother would usually tell the milkman the day before, but if she forgot the milkman would have extra supplies on his float to meet our needs. Of course, if all his customers did this, he wouldn’t have been able to accommodate them. But that was never likely to happen – except at Christmas, and the dairy made contingency plans for that.
The ready availability of everyday produce is, in this sense, an illusion. An illusion widely, and productively, employed in modern economics. Liquidity is the capacity of a supply chain to meet a sudden or exceptional demand without disruption. This capability is achieved, as it was by the milkman, in one or both of two ways: by maintaining stocks, and by the temporary diversion of supplies from other uses. When the supply chain lacks liquidity, consumers need to maintain stocks for themselves – they keep a spare pint of milk in the fridge. The financial analogue of the spare pint is the necessity for businesses and households to maintain monetary balances. In extreme cases of illiquidity, households end up hoarding cash under the bed. These supply chain inefficiencies may be costly, in both the milk supply chain and the money market.
Nothing illustrates the self-referential nature of the dialogue in modern financial markets more clearly than this constant repetition of the mantra of liquidity. End users of finance – households, non-financial businesses, governments – do have a requirement for liquidity, which is why they hold deposits and seek overdraft or credit card facilities and, as described above, why it is essential that the banking system is consistently able to meet their needs.
But these end users – households, non-financial businesses, governments – have very modest requirements for liquidity from securities markets. Households do need to be able to realise their investments to deal with emergencies or to fund their retirement, businesses will sometimes need to make large, lumpy investments, governments must be able to refinance their maturing debt. But these needs could be met in almost all cases if markets opened once a week – perhaps once a year – for small volumes of trade….
The need for extreme liquidity, the capacity to trade in volume (or at least trade) every millisecond, is not a need transmitted to markets from the demands of the final users of these markets, but a need, or a perceived need, created by financial market participants themselves.
Kay also discusses robustness versus efficiency that will be familiar to readers of this site (or of Richard Bookstaber’s A Demon of Our Own Design, or Nassim Nicholas Taleb, who we’ve cited regularly).
Again, this is a very accessible speech with a lot of meaty material in it. I hope you’ll read it in full.