Sunday, April 12, 2009

What in the world is liquidity?

For some reason every time I start my computer this page drops down as one of the most recent websites I've visited. It's a NY Times article from May 2nd, 2008. The headline is

Fed takes steps to add liquidity

Besides the confounding fact that it won't go away, this headline is significant for the remarkably ignorant use of the word 'liquidity.' Somehow, many people use the term liquidity when what they really mean is money. The suggestion is that by adding money, which is what the Fed technically does, they are by definition adding liquidity. So, as the Times headline shows, the money comes to get reported as liquidity.

The problem is, not all money is liquid money. That is, not all money is easy to get and trustworthy to lend. Under certain conditions money can be like that, but not always. So, yes, the Fed can just 'add' money, but no, it can't just 'add' liquidity. Not unilaterally anyway. Liquidity is created in time and context and requires on-the-level institutions and willing players. Plural. People interacting. More specifically, liquidity needs people interacting within an acceptably stable and understandable field of organized regulations. Credible and confident people, in other words, working within socially accepted parameters.

We don't have these conditions right now, and we will lack these kinds of people, at least in the near term, no matter what the Fed does. The question is whether high levels of liquidity can possibly return in the medium- and long-terms. If so, than we would do well to get our house in order and, through a little fiscal discipline, restore our seemingly natural state of credit-worthiness. If, on the other hand, conditions being as they might be, a return of liquidity simply isn't in the cards, we will need a whole new system of wealth-creation. In this case, economic growth will depend again on actually being productive.

In a way, what I am saying is a lot is riding on what we come to know about liquidity. Headlines like this, which tell me we can't even define our words let alone gain a semblance of control over them, make me less confident.

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