Sunday, May 23, 2010

Liquidity is dangerous

If I had a hammer, I’d hammer out danger, I’d hammer out a warning…With apologies to Peter Seeger & Lee Hays

The authors might take umbrage at using their lyrics (LYRICS - If I Had a Hammer) when discussing anything as crass as money. However, hopefully one doesn’t need a hammer to teach love between my brothers and my sisters. Maybe a bell and a song will do and they can lend me the hammer. It’s a little harder to teach a little financial common sense to powerful people with vested interests. Nevertheless, here’s some food for thought.

If, as the profs theorize, risk is price volatility and volatility requires liquidity, it is only a short hop to excess liquidity will produce excess volatility. But, volatility can be endured. There is a side argument that excess volatility discourages capital formation, producing a sub-optimal bias in favor of consumption -- an argument many profs overlook. But, that side argument isn’t what this posting is about. This posting is about a sub-optimal allocation of whatever capital there is. It seems I am not alone in noting that the blind pursuit of liquidity is compromising transparency and the market maker role of exchanges. I recommend reading " Stock Market Mayhem Confirms Need for Better Regulations - .

This is an excellent article. However, The Hedged Economist argued that the “flash crash” is not very mysterious (see: “The day the computers panicked” in PART 1 of a three part posting). Interestingly, I reached the same conclusion as the article about transparency and the blind pursuit of instantaneous and continuous liquidity (see: “The false God of transparency” the last posting). However, this blog broached the issue of how much liquidity is needed back on January 28 in “Efficient capital allocation doesn’t require perfect liquidity” in one of the first postings on this website.

Why the hammer? Because this is fast becoming a potential source of the next systemic meltdown. I can’t emphasize enough: efficient capital allocation doesn’t require perfect liquidity. It is time to add: efficient capital allocation can’t survive perfect liquidity if perfect liquidity requires sacrificing price transparency. Neither liquidity nor transparency is a God, but there are aspects of both that are needed for markets to function.

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