Media Briefings

Liquid Capital And Market Liquidity – Understanding The Linkages

  • Published Date: October 2009


In times of financial market turbulence, central banks seek to ‘supply liquidity’, both by
bolstering overall market liquidity and by improving the balance sheet liquidity of financial
intermediaries. Writing in the October 2009 issue of the Economic Journal, Professor
Timothy Johnson explores these two distinct meanings of liquidity and their significance
for thinking about financial market fluctuations and policies to protect the resilience of
markets.
He notes that economists use the word ‘liquidity’ in a confusing variety of ways. Monetary
economists refer to an economic agent – a nation, a firm or an individual – as ‘liquid’ when
it holds a large fraction of its assets in a form readily exchangeable for needed goods and
services.
Financial economists, on the other hand, refer to a ‘market’ as being ‘liquid’ when the cost
of transacting – either buying or selling – are low and large amounts can readily be traded
at posted prices.
While these concepts are quite distinct, intuition (and some empirical evidence) links the
two: markets tend to be deeper when there is more cash around. Conversely, one aim of
central banks in ‘providing liquidity’ during times of turbulence is to bolster market liquidity
via improving the balance sheet liquidity of intermediaries.
Timothy Johnson's study asks why this should work, or why one form of liquidity should
affect the other.
The answer matters because protecting the resilience of markets is a crucial policy goal,
and quantifying the risks of transacting is important to investors. So it is perhaps surprising
to learn that the underlying mechanism may not have to do with the fortitude of
intermediaries.
Conventional wisdom suggests that when banks and brokers are flush with cash they can
then afford to make tighter two-sided markets. While not disputing this possibility, Johnson's
work points to a somewhat deeper channel.
The research views the economy's balance sheet as becoming more or less flexible over
time as agents choose to hold capital in investments with differing degrees of
transformability. (They typically like a mix, but their holdings get perturbed over time by
differing returns.) This ‘technological’ degree of flexibility is yet another definition of
‘liquidity’.
When a lot of capital is held in readily transformable form, it can then serve as a buffer
stock, allowing agents in the economy to cushion cash flow shocks that they may
experience from their various sources of income and expense.
Securities trading can be one such source of shock: if somebody else in the economy
needs to buy or sell assets, those on the other side of the trade are forced to alter their
holdings to accommodate – gaining or spending cash in the process.
The willingness to accommodate others' trade demands is the key determinant of market
liquidity. Thus, the argument goes, the overall willingness of agents to trade will be lower
when their supply of adjustable wealth is low.
In these situations, accommodating trades (‘supplying liquidity’) means absorbing bigger
adjustments to consumption, and more compensation will be required. For example, if
forced to buy one share at price P, the outflow of P units of cash will entail a relatively big
loss of consumption. This will lower prices, meaning the price bid for a second share will be
significantly below P.
The effect works the opposite way if the trade demand is for a purchase rather than a sale:
prices will move up more when buffer stocks are low. Prices thus respond more to volume
when the economy's overall supply of available capital is lower.
The effect that Johnson’s research highlights has nothing to do with credit market frictions
or details of trading microstructure. It thus cautions against the assumption that declines in
market resilience are caused by breakdowns in the trading process. In particular, limited
willingness to trade when cash is limited is not necessarily evidence of systemic failure of
capital markets.
More broadly, the study traces the impact of fluctuations in the supply of transformable
capital on other stock market characteristics. By serving to buffer consumption from income
shocks, liquid savings lead directly to lower volatility, lower risk premia and lower discount
rates.
The theory thus offers an explanation, not just for ‘liquidity crises’ but also for the apparent
asset market inflation that accompanied the so-called ‘savings glut’ only a few years ago.
The subject of much (now forgotten) concern at the time, ‘excess liquidity’ was widely seen
as leading to irrational mispricing and disregard of risk. Johnson's study offers an
alternative interpretation.
In sum, even if we lived in a world with no market frictions and no brokers, we might still
observe the main qualities of the stock market changing over time with the rise and fall of
the supply of deployable capital. Johnson's analysis provides an explanation for these
linkages based on fundamental economic principles.
ENDS
Notes for editors: ‘Liquid Capital and Market Liquidity’ by Timothy Johnson is published in
the October 2009 issue of the Economic Journal.
Timothy Johnson is at the University of Illinois at Urbana-Champaign.
For further information: contact Timothy Johnson via email: tcj@illinois.edu; or Romesh
Vaitilingam on 07768-661095 (email: romesh@vaitilingam.com).