Liquidity: The Third Fundamental Force of Economics

As every economics student knows, supply and demand are the two dimensions that, given units of quantity or price, determine the equilibrium for a commodity, where there is no inefficiency in the market. It’s a very simple, but elegant idea – given that there is an inherent shape to the supply and demand curves for a commodity, at some unit of quantity and price there is an equilibrium point where, all things held equal, the most efficent arrangement for the distribution for that commodity begins to emerge.

Of course, as we are well aware, things are not always held equal, and markets are not always efficient. In fact, empirically we typically observe that markets are inefficient more often than they approach efficiency. Indeed, there can be value (in the philosophical sense, and maybe even in the economic one) in inducing slight inefficiencies into the economic system. There are many variations on this argument, but all inefficiencies stem from human nature and the state of human existence.

Take, for example, the example of retirement savings. If you’re lucky, during your working life, you will save a substantial amount of money and invest it in any variety of vehicles, depending on your appetites for risk and complexity. The conventional calculation for retirement savings is to assume that your money grows, on an annualized basis, every year in a reliable manner. Taking this trend to the extreme, then, is it not the most efficient use of resources to keep that money invested and generating returns indefinitely.

Of course, the problem with this is that you eventually stop working, and as you near the end of your life you will draw down on those funds as needed. While this is not the most efficient use of resources, it is an inevitable one, and human mortality does not seem to be an undesirable source of inefficiency in financial markets.

Now, let’s make a few small changes to the scenario. Let’s say you’re the largest pension fund in the United States, the market has been on a strong bull for the past six years, and your portfolio has strongly outperformed the market in each out of those years, both as a result of prudent picking and the scale that you have achieved. People want to manage your money because they see it as endless and reliable.

Now for the bad news – unlike individuals, pension funds are also subject to intervening political and environmental variables. Let’s say that, about 20 years ago, a new administration took office and made strict cuts to the size of the work force, either by reducing starting salaries or reducing hiring. Either way, you’ve got a lot of people who have invested a lot of money in your fund who are about to retire, and the amount of money that is being paid into your fund is not quite the same.

Typically, this is a workable situation. You’ve invested these people’s money in securities for a reason. If you need to generate some cash to start paying out, just sell those securities. However, sometimes it’s not that simple. What if, after six decades of a bull market, things turn around for the worse, maybe a 10 or 20% correction? It happens every now and then. The problem here is that while you are in a selling mood, so is everybody else. You’ve got folks who need to be paid, and nobody wants to buy your assets to help you generate the cash, or at least not without an enticing premium to make it worth their while.

This example illustrates the vast importance of liquidity in financial markets. In an efficient market, there is always somebody who wants to buy what you want to sell, and you don’t need to sell unless you want to. However, because the world is inefficient, liquidity, which is defined broadly as the ability to buy or sell an asset without changing its price, plays an important role in selecting the most appropriate assets for your investment goals. This rings true regardless if you’re an individual, a penion fund, or the world’s largest sovereign wealth fund.

In the case of the pension fund, because they are required to pay out money to their investors, that means taking a hit up front in order to move enough assets to generate the cash to make payments. Many hedge funds specialize in just this kind of transaction. Because they have a longer horizon for risk, and because they have experience with arbitrage in their business models, they may be willing to pay for an asset at a discount on the bet that they will be able to move it later at a price closer to its efficient market value.

To this end, liquidity and its relationship to external shocks is just as important as supply and demand in determining the state of a financial system. When combined with leverage, you may achieve liquidity crises such as the financial crash of 2008, or external political factors lead to runs on banks, such as those which are happening in Greece right now.