Against Liquidity Keynes Himself Contends in Vain
Robert Waldmann
Two quotes about liquidity.
it is in everyone’s interest that markets be as liquid as possible. One of the factors increasing the risk of downward-spiraling markets is illiquidity – i.e., the possibility that assets may be difficult or impossible to sell when necessary either because there is no ready market or because of barriers to sale such as the lack of common standardization (and subsequent need for costly negotiation and legal review) that ISDA has helped remedy.
(notice this is a super top secret e-mail as Marshall always suppresses readers’ names. Anonymous didn’t want even Marshall to know.)
The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like a marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment. For the fact that each individual investor flatters himself that his commitment is ‘liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma. So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organising markets wherein these assets can be realised for money.
(Keynes 1936:161)
(hey look at that url. I swear it was the first google hit for the quote).
There does seem to be a certain divergence of views here. Keynes reluctantly concludes that common stock should be made 100% illiquid by making it like a marriage (and a marriage in 1936 was not like a marriage in 2009). Anonymous assumes that more liquidity is always better.
Note that anonymous assumes that positions which someone wants to liquidate just magically appear. It’s not as if liquidity causes people to take huge leveraged positions because the fact that each individual investor flatter[ed] himself that his commitment is ‘liquid’ (though this cannot be true for all investors collectively) calm[ed] his nerves and ma[de] him [too] willing to run a risk.
The case for liquidity is rather undermined by Keynes’ parenthetical observation. The fact is, no matter how liquid assets are, if everyone tries to liquidate them, everyone will take a bath. Anonymous’s failure to notice this *after the fact* helps explain how liquidity managed to destroy the financial system.