All That is Liquid Freezes in a Panic

Argue against a complex financial practice, and you’ll hear it sooner or later: the liquidity trump card. Promoters of virtually every form of securitization, leverage, collateralized debt obligations, credit default swaps, swaptions, you name it—will insist that, if their activity is regulated or limited, the markets will lose liquidity. For example, as John Cassidy quotes John Mack, ‘subprime-mortgage bonds . . . “give[] tremendous liquidity to the markets.'” Another private equity executive tells Cassidy, ““Part of the value in a stock is the knowledge that you can sell it this afternoon. Banks provide liquidity.’”

Having authored the perceptive book How Markets Fail, Cassidy looks behind the liquidity talisman and finds it tends to melt into cliche:

“Liquidity” refers to how easy or difficult it is to buy and sell. A share of stock in a company on the Nasdaq is a very liquid asset: using a discount brokerage such as Fidelity, you can sell it in seconds for less than ten dollars. A chocolate factory is an illiquid asset: disposing of it is time-consuming and costly. The classic justification for market-making and other types of trading is that they endow the market with liquidity. . . .

But liquidity, or at least the perception of it, has a downside. The liquidity of Internet stocks persuaded investors to buy them in the belief they would be able to sell out in time. The liquidity of subprime-mortgage securities was at the heart of the credit crisis. Home lenders, thinking they would always be able to sell the loans they made to Wall Street firms for bundling together into mortgage bonds, extended credit to just about anybody. But liquidity is quick to disappear when you need it most. Everybody tries to sell at the same time, and the market seizes up. The problem with modern finance “isn’t just about excessive rents and a misallocation of capital,” Paul Woolley said. “It is also crashes and bad macroeconomic outcomes. The recent crisis cost about ten per cent of G.D.P. It made tackling climate change look cheap.”

Just like the portmanteau terms “growth” or “innovation,” liquidity is the start of an argument, not the end of it. We need to ask why it is socially valuable that certain forms of investment can be quickly bought and sold.

The liquidity fetish is part of a larger project in finance—what Manhattan Institute Scholar Nicole Gelinas characterizes as a quixotic (and dangerous) quest for a “risk-free world.” Her book After the Fall: Saving Capitalism from Wall Street—and Washington is well worth reading. Both Cassidy and Gelinas challenge the finance world’s soundbite selling points for endless “hedging” and “risk management.”

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