Paul Krugman’s Argument is Liquidated when it’s Specious Character is Revealed

Got you to look. I am using 18th century English, the title translates into 21st century English as “Paul Krugman’s Argument is clarified when the fact that it is precise is revealed”

Krugman objects to Stephen Schwarzman’s use of the word “liquidity” which, he claims, conflates two different meanings. I think the word should be liquidated with extreme prejudice — it has at least 4 different meanings (counting neither the 18th century meaning “clarified” and the one I just invoked in an attempt at humor).

Kruman notes two

I’m pretty sure that the word “liquidity” is being used to refer to two somewhat different things. One is liquidity in the normal sense of “thick markets”, in which someone who wants to sell assets quickly can find buyers without offering fire-sale prices. The other is closer to arbitrage — the presence of investors who will buy assets that are obviously underpriced, and in so doing prevent big deviations of prices from fundamental values. These two things could be related, but aren’t the same — a market in which an individual investor can sell $10 billion in bonds without causing ripples might also be a market in which nobody will step in to buy bonds after a taper tantrum, and vice versa.

and adds

most of the evidence being presented seems to be more about the first issue than the second — bigger intraday swings and so on, which in and of themselves matter only to a handful of players.

Another one of my favorite topics. Keynes also objected to the uses of the word liquidity writing “Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity,” Against “liquidity” Keynes himself contended in vain. But Keynes meant something very different from either of the two meanings Krugman discussed. He went on to define the fetish of liquidity as “the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities.” This meaning of “liquidity” isn’t market thickness nor is it deep pocketed arbitrageurs — it is ownership of a lot of liquid securities. This is the early 20th century meaning as in “liquidity preference” a phrase which is, as far as I know, used in the 21st century only by Brad DeLong.

I think there is a fourth meaning of “liquidity” and that this is a form of liquidity which is very dear to the hearts of financiers — not “the presence of investors who will buy assets that are obviously underpriced, and in so doing prevent big deviations of prices from fundamental values. ” but “the presence of investors who will buy assets that are obviously overpriced, and in so doing, make the gains from detecting obvious mispricing enormous.”

I read somewhere (no link because I forget where) that actively managed mutual funds are underperforming the S&P 500 partly because unsophisticated investors are shifting to index funds* — instead of becoming more profitable because there is less competition, stock picking is becoming less proftable because there is less competition by incompetents.

I ask why does this investor want to sell $10 billion worth of some asset ? It isn’t often because the investor suddenly needs $10 billion. I think much more often it is because the investor thinks the asset is over priced. If so, the thick market she needs is a market full of thick headed people who are willing to buy an overpriced assets.

It is certainly true that there is a large class of Albert “Pete” Kyle type formal models of market structure obtain market thickness (indeed obtain positive trading volume) only because of the presense of irrational noise traders. Without them, rational investors can’t make money by obtaining information about future profits of firms.

Now I think it is easy to imagine that prudential regulation reduces the volume of the order flow from fools who are easily separated from their money. The prudential regulator is, in effect, saying “you can’t do that because it looks crazy to me” and this can easily happen if it is, in fact, crazy (it can also happen if the trade is made by a sane and sophisticated agent whose incentive contract was written by a fool who is easily separated from his money).

In my interpretation, Schwarzman is like the professional poker hustler who argues that laws banning high stakes poker are bad for society. They certainly are bad for professional poker players.

*typo corrected thanks to the, as yet still sane, JimV.