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.
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.
Since I think posters can edit posts for typos, I will mention this one: “investors are shirting to index funds”. Shifting? Or maybe there are multiple meanings for “shirting”, as for liquidity.
Very clever post title – made me look.
Thanks Jim. And posters can edit not only posts but comments as well.
But trust me on this point: as Robert himself will tell you ,policing his posts for typos is a ticket to madness. Not least because at times his word processor’s auto-correct is set to Italian and hilarity ensues.
In this case I am sure he means ‘shifting’.
I hereby tell you that policing most posts for typos is a ticket to madness. Believe me — I’m not bull shirting you.
And on the point of the post. It has always driven me crazy that economists of the classical variety will insist that prices are set in a market of fully-informed economic actors while at the same time there is a multi-billion dollar industry of investment advisors and peddlers of newsletters to inform the “fools” that there are ways to “beat the market”. Which clearly implies asymmetric information or superior analytic methods.
Yet this fundamental and obvious truth seemed so obscure to the economics professional that Ackerlof got a Nobel (or Sverige Bank) in large part for his work on ‘Lemons’. Which is to say how markets are directly exploited by asymmetric information and not just on the car lot that was his headline example.
I think this from The Reformed Broker (apud Delong) may be the link you have forgotten? On Feb 17, he said::
But the issue Larry Swedroe highlights – about the retail migration away from “playing the game” – is probably the more important secular problem for active managers. Minus the exploitable accidents of large numbers of mom and pop investors, there’s simply less alpha to go around. The low hanging fruit has left and gone to Valley Forge, PA. In the absence of so many unskilled players, the field has become much more brutal, much more difficult to best.
Robert – As you say, there are many definitions of liquidity. I think you have to look a bit deeper to understand why some folks in the markets are concerned with liquidity.
The biggest market of all is the US Treasury market. This market has been suffering from liquidity problems for several years.
To look at this you have to consider how many of the issues are trading “special”. Then you have to look at the pricing of the bonds that have gone special, you also have to look at the the “failure to deliver” rate.
This year about 3.5% of all treasury transactions result in a failure to deliver. That’s a very big number. The reason for the fails is a lack of liquidity. The failure rate is concentrated on those issues that have gone special.
For example, on June 12th the 10 year US Treasury bonds traded in the repo market at -2.2% while at the same time 7 and 30 year collateral traded at +15 BP. So the entire ten year sector of the market went special, and as a result fails exploded.
This is the 4th time this year that the 10 year has gone special. It is not just the T-bond market. This problem has gone global. It is not in just bonds – it’s stocks/commodities too. Many individual issues suffer flash crashes – this happens on a nearly daily basis. Another area of concern to me is in FX. If you traded FX you would understand the liquidity issues that keep popping up.
The WSJ sums up the issues in the T bond market:
There was a flash crash in the USD on June 12. The graphs show how liquidity just vaporized on this day:
PS – both you and PK refer to something about a $10m trade in bonds. The concern is not about such a small trade. The T market trades in 10B chunks – 10m is just a rounding error in this casino.
PK: — 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.
RW –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.
Krasting — PS – both you and PK refer to something about a $10m trade in bonds. The concern is not about such a small trade. The T market trades in 10B chunks – 10m is just a rounding error in this casino.
I mean that is not even a strawman, more of a vapor man. Does your need to bigfoot and condescend to EVERYONE trump your basic reading ability? That must be the most wasted PS in history.
And what do you mean by trading “special”? Because your WSJ is behind a paywall and the Zero Hedge is just some graphs about the USD market with some side reference to Treasuries that make little sense and probably have no real meaning outside day trading. Mostly index trading IS just casino gambling and sits at a couple of removes from any real world liquidity questions.
But I am still confused by “special” here. Certainly this has nothing to do with “Special Treasuries” as normally defined. Some Googling brings up this relating to “on the run bonds”
” Due to the extreme liquidity of these investments, on the run Treasury securities occasionally experience special repo rates or, in financial parlance, go “on special.” This typically occurs when investors bid up the price of certain on the run Treasury securities as part of an overall hedging strategy. On the run Treasury notes and bonds typically are slightly more expensive than previous issues due to their higher liquidity and greater demand for the newer issues over older versions of the same securities”
But it is hard to get from here to what mostly reads like word salad in your comment. Maybe you are making sense but it is all jargon impenetrable to anyone outside the bond market itself and to this point of doubtful relevance to either discussion of overall liquidity or economic conditions in general. Some bond traders got spooked, why is this important?
Webb – Bond traders didn’t get spooked. A shortage of collateral (liquidity) caused the repo rate to fall relative to other maturities.
The repo market is big. $5T in the US double that outside the US. The US repo market is the biggest source of liquidity in the world. The US Treasury repo market is the benchmark for the global swaps market (gazillions). The ten-year treasury repo market is also a benchmark as the 10 year is the most traded bond for cross hedging risk.
Why does this matter? An example.
California comes to market with a $3b 10 year Muni Bond. Wall Street underwrites the offering, it gets completed without a hitch. Just the way you would hope it to.
Wall Street dealers don’t have $3b to pay California, so they do reverse repos to create the cash needed. The dealers don’t take risks on this (Dodd Frank reduced risky behavior by banks). So they hedge the interest rate risk by selling short 10 year Treasury paper (a hedge). But the dealers don’t have the bonds they just sold, so they now must go into the Repo market to get the collateral they need (or fail). So the very standard Muni deal is dependent on $6B in reverse or straight repos. This is how it works.
The example I give happens dozens of times a week in the US, a dozen more times more outside of the US.
But when the 10 year goes special it mucks up the hedging costs. Who pays for this? The dealers? No – California pays for it.
I see trees, you see a forest. The view of the forest is sanguine, but there are a fair number of sick trees. My concern is that these things are happening on a regular basis when interest rates are at zero. What happens when that is no longer the case?
The idea that actively managed funds underperform the S&P because people are shifting to index funds ignores that actively managed funds have, on average, always underperformed the S&P. It’s not a new phenomenon.
Maybe we need to add another to the list of liquidity types: Digital trades.
How does the concept of liquid work in a world where 85% or so of all trades are simply math algorithms not to mention the interception of the data before it hits the trade floor.