Liquidity has the distinction of being important to individuals, businesses and governments. Clearly it is vital to the whole economy also, but there it is somewhat elusive and mysterious.
A liquid asset is either cash itself or an asset that can quickly be converted to cash and be used for purchases or to pay debts. Liquidity is usually measured not by the amount of liquid assets but by comparing that amount with the financial obligations it must meet.
For individuals, liquidity means being able to pay your financial obligations on time. In its simplest form that translates to matching the incoming cash flow from paychecks or other income to the outgoing cash flow to mortgage or rent payments, real estate taxes, credit card payments, utilities, groceries and similar periodic bills.
For businesses, liquidity means the same thing, but it is measured somewhat differently, largely because business transactions often require more elaborate record-keeping systems.
Business liquidity is measured initially by comparing the firm’s current liabilities to the amounts available to pay them, the current assets. Three ratios, “Current,” “Quick” and “Cash,”reflecting increasing levels of liquidity, are the most commonly used but some businesses require liquidity measures tailored to their specific operations.
The fundamental principle of liquidity, the ability to meet obligations when they come due, remains the same for individuals as for big corporations. It is even the same for the most complicated, multi-dimensional derivative scheme that ever made a Wall Street trader’s mouth water.
Government liquidity is measured by its ability to meet its financial obligations in a timely manner. It is different from individuals and businesses, though, because government has responsibility for the money supply itself. The most visible example of this is when a government finances its growing expenditures by debasing its currency — paying on time but with cash whose value has been discounted by inflation.
While we know a lot about liquidity for individuals, businesses and government, in the total economy and the financial markets that serve it liquidity is another matter. There it is not easily defined or measured. As a recent report from the Bank for International Settlements noted, “Indicators tend to measure these ‘footprints’ of liquidity rather than liquidity itself, which is unobservable.”
One of those indicators, or footprints, is trading volume. Brokers and investment managers, for example, speak of “thinly traded” securities to indicate that the stock or bond may present a liquidity issue. A seller might have to wait to find a buyer in order to convert that security into cash, for example, or perhaps take a big hit in price to speed up the process.
What we know about market liquidity is that it is important, even vital, to a healthy, growing economy. We also know that it is influenced by many factors … and can evaporate almost overnight, as it did in some crucial markets in 2008.
What is happening in today’s global financial markets is not a sudden disappearance of liquidity, but a preferential shift that is concentrating liquidity in a few types of government securities, mostly at the expense of corporate bonds.
What this means to investors who hold corporate bonds is that they might not be able to convert them quite as quickly into cash. What it means to corporations is that they may have to look to other sources for long term financing, such as issuing common stock.
Although it doesn’t really look like it, the shift could be a form of market correction to align the bond market with both lowered corporate profit forecasts and increasing concern about economic growth.
If you are a worrier, though, market liquidity issues always prompt concerns about the ability of our financial institutions to weather a severe liquidity crunch — and the ability of our central bank to abate the problem and keep it from spreading to the rest of the economy.
Large financial institutions are now given “stress tests” to examine their ability to withstand the losses and market volatility associated with a severe recession. Our major banks have adapted to these recurrent tests and restructured their operations to accommodate the higher capital requirements that come with them. So they are ready — if history repeats itself and the next market crunch is like 2008 all over again. If a liquidity crunch develops in a different way, though, it could be difficult to prepare for it.
It is still difficult to tell if the market liquidity issues we’ve seen so far are serious or just the market being the market. As Alfred E. Neuman of the “What, Me Worry?” school of thought might say, “If what investors really want is government debt, don’t worry. We’ve got plenty of it.” That’s one way to look at it.
James McCusker is a Bothell economist, educator and consultant. He also writes a column for the monthly Herald Business Journal.
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