Following on from his last post about the BOE Open Forum our guest economist and respected monetarist John Hearn has this to add on market liquidity

The many meanings of liquidity

At the recent Bank of England Open Forum it was necessary to ask questions using an IPAD supplied by the Bank. I asked a number of questions about the current impact of Bank of England policy and none of them seemed to get to the Chair of the various meetings. I eventually realised that my questions were being vetted and not sent through. Any questions which were critical of banks with a small "b" were getting through and I realised this when it was explained to the audience that there were no more questions and with a little more time to go would anyone like to ask a question from the floor?

I asked whether any of the panel felt that a 0.5% Bank Rate was causing distortions in the structure of interest rates in financial markets and possibly leading to asset bubbles. The Chairman asked if anybody would like to answer this question. Everyone shook their head and I was politely thanked for my question and the event moved on.

There was some compensation when I was interviewed by the BBC and asked about the need for financial literacy in education and I was able to suggest that I had observed a lot of financial illiteracy among the experts on the day and this led me to identify the most commonly misused word which was "liquidity" and for my students I offer a brief explanation of the various meanings of liquidity below:-

Liquidity

There is a spectrum that ranges from very liquid assets to very illiquid assets. The most liquid asset is legal tender as it can be used to settle all debts in law. Money is slightly less liquid in its non-cash forms as people can refuse to accept credit cards and cheques in settlement of debt. Following this there are assets that can be turned into cash fairly easily and then less easily through to a range of illiquid assets that are very difficult to turn into cash over short periods of time.

Personal liquidity

This is measured by a person`s ability to access money which could be their own demand for money as they choose to hold their own assets in liquid form or it could include access to other people`s money that they wish to borrow and can service in a sustainable way. Usually this money will be held as idle cash balances in the purse or wallet or in a current account or as near money in an account that can be turned quickly into money.

Private sector company liquidity

This is the ability of a firm to settle all debts as they arise and over the longer term to be able to sustain this while achieving at least normal profits: the minimum level of profit that will keep the firm in the industry. As with private liquidity, companies will have current accounts sourced from own funds and sustainable loans that can be used to settle debts.

Public sector liquidity

Liquidity in this sector is sourced from the very deep pockets of the taxpayer and government debt. It is often changed as the result of policy and Treasury directives. From previous evidence it is the least constrained form of access to liquidity.

Bank liquidity

This stands alone as being different from all other forms of liquidity as it requires a bank to be able to satisfy everyday customer demand for cash. I remind you here that all cash is money, but not all money is cash. Other forms of liquidity described above and below relate to the demand for money whereas for a bank it is a demand for cash that is important. A person who goes to an ATM and withdraws £100 will not accept a cheque from the bank, they require the bank to settle all these demands in the printed and minted form. This means that when a bank is creating new loans for customers it is limited by its access to cash.

Market liquidity

This is something of a misnomer as all markets can face liquidity problems: see Macro-liquidity, but individual markets are unlikely to be illiquid if all other markets are described as liquid. A market may be referred to as illiquid when in fact the problem is most likely to be that it is an inefficient market. There is unlikely to be a shortage of buyers or sellers if the price is right and there are no constraints on bringing buyers and sellers together. For example when interest rates rise there will be a shortage of buyers for houses and a surplus of sellers and these sellers will be reluctant to lower prices as they fear not being able to buy another property at a reduced price. This means that the market will be described as illiquid for a period of time until prices have sufficiently adjusted.

Macro-liquidity

The economy as a whole is described as liquid when there is sufficient monetary demand to exchange all goods and services at the current level of prices. As the Bank of England manages monetary demand, and it is uncertain about how fast the real output of the economy will grow, it tries to expand monetary demand at a rate that is at least 2% faster than the rate of growth of output. This hopefully will ensure that it achieves its 2% target rate of inflation. If monetary demand does not grow at or above the rate of growth of output then deflation will result and the economy as a whole will become less liquid as prices on average will have to fall to allow trade in the real product of the economy.

Deflation creates the additional risk that if it continues then people may start to change their spending habits and hold back purchases in anticipation of further price falls. This reduces the velocity of circulation of money and creates the situation that was expected, namely a further fall in prices. In effect the deflationary situation exposes weaknesses in all markets as they try and adjust to lower prices.

John Hearn 2015