![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
The liquidity flows down to the sea
Sep. 18th, 2013 12:36 pmAn interesting article in today's FT by John Kay about liquidity. Kay's piece was about defining it, but I am more interested in the fact that it's a movable feast.
There are quite a few simple rules in emodern economics. One of these is that liquidity and volatility have a value. If a stock is fundamentally worth, say, $100 but the company's earnings and dividends are volatile, then that stock will trade at a discount to its fundamental value. Contrariwise, if a company's earnings and dividends are solid, then that stock will trade at a premium to its fundamental value.
The same goes with liquidity. If a good (say, a stock where there isn't much in free float) is "illiquid", such that if you want to sell a lot of it, you won't be able to get the current marked price, then that stock will trade at a discount to fundamental value. If it's highly liquid (like, say, Vodafone or BP) then it will trade at a premium. That difference is most easily spotted in the size of the "spread".
These amounts aren't massive, and are masked by lots of other bits of noise. The most obvious one is whether the stock is or is not a growth stock. If a company has volatile earnings, but is seeing turnover and profits grow rapidly, the second factor (strong future expectations) will probably lead to the stock trading at a premium to fundamental value. If the stock isn't growing at all, it doesn't matter how rock-solid it is, it will probably trade at a discount, because the stockmarket believes in the principle that, like the shark, if you stop moving forward, then you die.
So, liquidity has a value. This leads to the belief that liquidity is good and illiquidity is bad. This in turn, after the 2008 crisis, led regulators to come up with reams of tougher laws on the kind of capital financial institutions ought to hold. Roughly, this ran along the lines of "you must hold more capital and the capital you do hold must be more liquid".
Note that the regulators did not insist that the banks hold "a pound for a pound". Some people question this. They question it more when it comes to poker sites, which they instinctively feel ought to hold a pound in the bank for every pound on deposit. And, if they don't, well, they aren't solvent.
John Kay came up with two neat examples of how this attitude is unrealistic. One is that I assume, for example, that I can catch a 63 from Southwark to the office, should I so desire (I usually walk). There could be 20,000 or more other people (I really have no idea how high the number is) who operate under the same principle. But no-one suggests that the bus company run a sufficient number of buses to cope with the (impossible) eventuality that everyone who considers it an option might decide to catch the 63 bus on the same day. The only accession to volatility is that demand might well go up when it rains, and the buses need to be able to cope with that not-infrequent event, or reputational damage would ensue.
Now, in financial circumstances, things are, indeed, slightly different. The first is the famous "run on the bank". This is the situation whereby, because people know that there isn't "a pound for a pound", they fear that everyone else WILL try to take out their cash. That would bankrupt the bank, so you rush their first. The "run on the bank" is a simple extension of the prisoner's dilemma. That fear was stopped in the most recent example in the UK (Northern Rock) by a government guarantee. A similar trick was tried by the ECB around 2009, where a huge amount of money was guaranteed in the hope that this would settle the bond markets in Italy and Spain (it did).
However, this has not stopped the new liquidity rules having some odd side-effects. As I wrote five years ago, it's important to distinguish between a liquidity crisis and a solvency crisis. Coggan in "Paper Promises" points out that one of the key functions of money was as "a store of value", while another was as "a medium of exchange". These are two sides of the same copin and when you move too much in one direction (the "store of value") you get a liquidity crisis, because everyone is putting their money into the mattress. If you move too much in the other direction (the "medium of exchange" ) then you head towards hyperinflation, because no-one wants to hold onto notes in which they have no faith.
Money, just like the number 63 bus, is a balancing act. If everyone decided to walk instead of catching the bus, then before too long the buses would cease to run (the economy would seize up). If everyone (for some insane reason) decided to travel on the 63 bus not only when they needed to, but also when they didn't need to, then the system would also fail, because the utility of the bus (helping people who needed to get from point A to point B to do so) would be flooded out by people travelling on the bus even though they didn't want to go anywhere.
The regulators thus get a little bit confused. Their insistence on banks holding a greater amount of liquid capital that could be used in a time of crisis is, perversely, serving to reduce liquidity. QE gets pumped into the system, and the banks promptly put it in the mattress. It also, equally paradoxically, doesn't work. because, if a time of crisis DID come, the chances are that the stuff that the banks put into the mattress wouldn't be wanted by anyone anyway.
The UK government appears, belatedly, to have spotted this. They might also have spotted that the compensation paid as a result of PPI misselling had a greater positive impact on the "real" economy than did QE (which served to increase my wealth by pushing up asset prices, but didn't serve to increase my expenditure in the slightest). Hence the cheap mortgage plan. Ignore what Osborne and Cameron say -- the plan here is to pump money into the economy that, even though it will only create an asset bubble, with little knock-on impact on the real economy (Allied Carpets, Ikea and the like excepted) it will serve to make a number of people "feel" better off. That, as we know, can serve to increase consumption for no logical reason. But all that the government cares about is 2015. At the moment, their plan seems to be working well.
There is another odd thing about liquidity -- the rules as applied to pensions are odd. The fact is, we do not have a pensions crisis. Yes, the system is unsustainable. Yes, there is a pensions deficit in a number of company schemes. But it is no more a crisis than saying "what if everybody suddenly decided to catch a 63 bus tomorrow?" What we have is a pensions problem - a fundamental shortfall. But that shortfall is not going to manifest itself tomorrow, or this year, or next, or even over the next decade. And it's not a problem that can be solved by telling pension funds that they can't invest in equities.
Imposing investment rules on pension funds that require then to match liabilities to assets has long-distorted the bond market. Requiring companies to top up funds (or cease making contributions if times are good) completely ignores that term we used when we came in - volatility. Pension funds really can take "the long view" and they can afford to accept volatility. But at the moment they are barred from so doing. That gives hedge funds and other companies such as Berkshire Hathaway carte blanche to sweep up for their investors (usually the already rich) the profits that should accrue to ordinary pension funds, whose stakeholders are usually the not so rich.
Eventually this is a problem that actuarial tables will solve -- people on final salary pension schemes will die off, having ripped off the rest of the population for an average of about £100k each (a wild guess probably on the conservative side) after counting the amount that they put in compared with the amount that they took out. The state pension meanwhile will become means-tested. The old "long-term sick" system will be tightened up considerably. Workfare will come back. It's not a happy prognosis. But one thing certainly isn't a solution -- muddling through with vote-winning tricks.
I am becoming increasingly convinced that democracy is a comfortable short-term situation that works only when times are good. When times are not so good the people will always vote stuff for themselves today at the expense of the generations to come. No government that tries to tell the masses the truth will ever get elected. And politicians will also cite single individuals rather than percentages (see Kahnemann on this topic on how it misleads the vast majority of people into taking two completely contradictory positions depending on how a question is posed).
_____________________
There are quite a few simple rules in emodern economics. One of these is that liquidity and volatility have a value. If a stock is fundamentally worth, say, $100 but the company's earnings and dividends are volatile, then that stock will trade at a discount to its fundamental value. Contrariwise, if a company's earnings and dividends are solid, then that stock will trade at a premium to its fundamental value.
The same goes with liquidity. If a good (say, a stock where there isn't much in free float) is "illiquid", such that if you want to sell a lot of it, you won't be able to get the current marked price, then that stock will trade at a discount to fundamental value. If it's highly liquid (like, say, Vodafone or BP) then it will trade at a premium. That difference is most easily spotted in the size of the "spread".
These amounts aren't massive, and are masked by lots of other bits of noise. The most obvious one is whether the stock is or is not a growth stock. If a company has volatile earnings, but is seeing turnover and profits grow rapidly, the second factor (strong future expectations) will probably lead to the stock trading at a premium to fundamental value. If the stock isn't growing at all, it doesn't matter how rock-solid it is, it will probably trade at a discount, because the stockmarket believes in the principle that, like the shark, if you stop moving forward, then you die.
So, liquidity has a value. This leads to the belief that liquidity is good and illiquidity is bad. This in turn, after the 2008 crisis, led regulators to come up with reams of tougher laws on the kind of capital financial institutions ought to hold. Roughly, this ran along the lines of "you must hold more capital and the capital you do hold must be more liquid".
Note that the regulators did not insist that the banks hold "a pound for a pound". Some people question this. They question it more when it comes to poker sites, which they instinctively feel ought to hold a pound in the bank for every pound on deposit. And, if they don't, well, they aren't solvent.
John Kay came up with two neat examples of how this attitude is unrealistic. One is that I assume, for example, that I can catch a 63 from Southwark to the office, should I so desire (I usually walk). There could be 20,000 or more other people (I really have no idea how high the number is) who operate under the same principle. But no-one suggests that the bus company run a sufficient number of buses to cope with the (impossible) eventuality that everyone who considers it an option might decide to catch the 63 bus on the same day. The only accession to volatility is that demand might well go up when it rains, and the buses need to be able to cope with that not-infrequent event, or reputational damage would ensue.
Now, in financial circumstances, things are, indeed, slightly different. The first is the famous "run on the bank". This is the situation whereby, because people know that there isn't "a pound for a pound", they fear that everyone else WILL try to take out their cash. That would bankrupt the bank, so you rush their first. The "run on the bank" is a simple extension of the prisoner's dilemma. That fear was stopped in the most recent example in the UK (Northern Rock) by a government guarantee. A similar trick was tried by the ECB around 2009, where a huge amount of money was guaranteed in the hope that this would settle the bond markets in Italy and Spain (it did).
However, this has not stopped the new liquidity rules having some odd side-effects. As I wrote five years ago, it's important to distinguish between a liquidity crisis and a solvency crisis. Coggan in "Paper Promises" points out that one of the key functions of money was as "a store of value", while another was as "a medium of exchange". These are two sides of the same copin and when you move too much in one direction (the "store of value") you get a liquidity crisis, because everyone is putting their money into the mattress. If you move too much in the other direction (the "medium of exchange" ) then you head towards hyperinflation, because no-one wants to hold onto notes in which they have no faith.
Money, just like the number 63 bus, is a balancing act. If everyone decided to walk instead of catching the bus, then before too long the buses would cease to run (the economy would seize up). If everyone (for some insane reason) decided to travel on the 63 bus not only when they needed to, but also when they didn't need to, then the system would also fail, because the utility of the bus (helping people who needed to get from point A to point B to do so) would be flooded out by people travelling on the bus even though they didn't want to go anywhere.
The regulators thus get a little bit confused. Their insistence on banks holding a greater amount of liquid capital that could be used in a time of crisis is, perversely, serving to reduce liquidity. QE gets pumped into the system, and the banks promptly put it in the mattress. It also, equally paradoxically, doesn't work. because, if a time of crisis DID come, the chances are that the stuff that the banks put into the mattress wouldn't be wanted by anyone anyway.
The UK government appears, belatedly, to have spotted this. They might also have spotted that the compensation paid as a result of PPI misselling had a greater positive impact on the "real" economy than did QE (which served to increase my wealth by pushing up asset prices, but didn't serve to increase my expenditure in the slightest). Hence the cheap mortgage plan. Ignore what Osborne and Cameron say -- the plan here is to pump money into the economy that, even though it will only create an asset bubble, with little knock-on impact on the real economy (Allied Carpets, Ikea and the like excepted) it will serve to make a number of people "feel" better off. That, as we know, can serve to increase consumption for no logical reason. But all that the government cares about is 2015. At the moment, their plan seems to be working well.
There is another odd thing about liquidity -- the rules as applied to pensions are odd. The fact is, we do not have a pensions crisis. Yes, the system is unsustainable. Yes, there is a pensions deficit in a number of company schemes. But it is no more a crisis than saying "what if everybody suddenly decided to catch a 63 bus tomorrow?" What we have is a pensions problem - a fundamental shortfall. But that shortfall is not going to manifest itself tomorrow, or this year, or next, or even over the next decade. And it's not a problem that can be solved by telling pension funds that they can't invest in equities.
Imposing investment rules on pension funds that require then to match liabilities to assets has long-distorted the bond market. Requiring companies to top up funds (or cease making contributions if times are good) completely ignores that term we used when we came in - volatility. Pension funds really can take "the long view" and they can afford to accept volatility. But at the moment they are barred from so doing. That gives hedge funds and other companies such as Berkshire Hathaway carte blanche to sweep up for their investors (usually the already rich) the profits that should accrue to ordinary pension funds, whose stakeholders are usually the not so rich.
Eventually this is a problem that actuarial tables will solve -- people on final salary pension schemes will die off, having ripped off the rest of the population for an average of about £100k each (a wild guess probably on the conservative side) after counting the amount that they put in compared with the amount that they took out. The state pension meanwhile will become means-tested. The old "long-term sick" system will be tightened up considerably. Workfare will come back. It's not a happy prognosis. But one thing certainly isn't a solution -- muddling through with vote-winning tricks.
I am becoming increasingly convinced that democracy is a comfortable short-term situation that works only when times are good. When times are not so good the people will always vote stuff for themselves today at the expense of the generations to come. No government that tries to tell the masses the truth will ever get elected. And politicians will also cite single individuals rather than percentages (see Kahnemann on this topic on how it misleads the vast majority of people into taking two completely contradictory positions depending on how a question is posed).
_____________________
