What’s liquidity? Is there too much or too little?

NEW YORK: Ask a trader about liquidity, and without missing a beat he’ll tell you it refers to the ease with which an asset can be bought or sold. Eurodollar futures contracts, Treasury securities and the Standard & Poor’s 500 Index are liquid. They can be bought and sold quickly, without incurring much of a cost in terms of a spread between the bid and the offered side of the market, and without influencing the price to any great extent.

A liquid asset can be converted into cash quickly. A Treasury bill is liquid; a house is not. Liquidity has another meaning, and that’s the one we’re concerned with here. It has to do with the provision of money by the central bank.

Don’t expect to get such a succinct definition from traders and investors — or even economists. Ask them what liquidity used in this sense means and you’ll get mumbo-jumbo in response.

I hear all the time that “there’s a lot of liquidity sloshing around the globe.” I’ve heard liquidity described, alternatively, as the pool of global savings, recycled petrodollars, the level of borrowing, the cost of borrowing, the ease of borrowing, and the level of interest rates.

What’s even more disconcerting is that economists can’t seem to agree whether there’s too much or too little liquidity. To look at the source of liquidity — the Federal Reserve’s creation of high-powered money — one would conclude that there isn’t an excess. The growth in the monetary base, which consists of bank reserves and currency, slowed to 3% in the last year from over 10% five years ago.

To look at liquidity’s effect — rising commodity prices and equity markets and narrow credit spreads — one would be tempted to conclude liquidity is ample. So which is it?

Former Fed governor Roger Ferguson dealt with this thorny subject in his remarks at the Seventh Deutsche Bundesbank Spring Conference in Berlin on May 27, ’05. “Liquidity is not a precise concept,” Ferguson said. “Liquidity could be measured narrowly as central bank money, for example, or more broadly to reflect the multiplier effects of the financial system; sometimes it is measured instead by the level of policy interest rates.”

Regardless of the definition, support for the conclusion that excess liquidity is “a source of general asset price instability” is “mixed at best,” Ferguson said, citing empirical research on the subject. Supply-siders — economists who see marginal and capital gains tax rate cuts as the sine qua non of economic growth — have been pushing the case for excess liquidity.

“Strong liquidity and low tax rates should power a global rebound in ’07,” writes Mike Darda, chief economist at MKM Partners in Greenwich, Connecticut, in his November Macro Focus. “The bear camp, flying high on the aphrodisiac of new home starts for October, may need to take a cold shower as strong liquidity, low tax rates and a stabilisation in the residential sector early next year pave the way for faster growth.”

With all due respect to Darda, the water temperature and designated bathers are up for grabs. “In my experience, credit spreads are a lagging indicator and, at best, a coincident indicator,” says Paul Kasriel, director of economic research at the Northern Trust in Chicago. “In ‘00, the stock market took a tumble just before the economy.

The lead time is not that great.”Kasriel doesn’t know what folks mean when they say “money is available” or “it’s easy to borrow.” Consumers are borrowing less, he says, and “corporations are borrowing more to buy back their stock. Corporations are the largest buyers of equities. If they were bullish, they would be expanding operations.” What about industrial commodity prices? The indices that exclude oil are near an all-time high.

“If the world is going through a transformation, and industry is shifting production to China and India, the world needs physical commodities,” says Jim Glassman, senior US economist at JPMorgan Chase. “The commodity price boom is a real story about economic development, a temporary increase in the demand for physical things,” he says. “They are confusing a real development story with a liquidity/inflation story,” he adds.