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Sunday, March 23, 2003

When Money is No Longer Liquid

I have spent part of this morning reading the latest Bank of England 'deflation watch' piece published in the latest edition of the quarterly review. In the midst of a relatively serious summary of the recent debate I find the following quote which really has set me thinking: "when we say that cash is more liquid than other assets we mean that it can, for example, be more readily transformed into something else that the owner wants". This seems innocuous enough doesn't it? It is probably after all a central tenet of all known monetary theory. But what happens when there is nothing else that the owner of a liquid asset wants than to hold the asset? Here I think we have the heart of the current debate and widespread misunderstanding about what is happening in Japan. There is in fact no charge for holding money. Now when interest rates are zero and deflation is running at two per cent, holding cash also attracts a positive real rate of some two percent, and apparently with no risk. In times of deep financial crisis (like the one which currently afflicts the Japanese banking system) the asset may even be considered by some to be safer under the bed than in a current account deposit where certain kinds of transaction may even attract charges. So the most liquid of assets ceases to be as liquid as it was (viscous perhaps, sticky money, etc, etc?), and herein lies the problem: everyone will accept cash, but not everyone is so willing to part with it. Oh, and just one more thing, printing money to acquire assets whose value may decline without provoking inflation (ie failing to provoke inflation) could be considered a cure worse than the problem if it only served to detriorate an already serious debt liability situation.

Goodfriend has suggested that the central bank could stimulate the economy by buying assets less similar to cash than normal: illiquid assets like infrequently traded bonds, or even claims on the private sector like shares or corporate bonds. An exchange like this would involve the private sector giving up an illiquid asset and taking a more liquid one, cash, in return. When we say that cash is more liquid than other assets we mean that it can, for example, be more readily transformed into something else that the owner wants. Money can be swapped for goods directly: other assets generally cannot. Having something that is more readily (more cheaply) turned into a good that can be consumed is valuable. Following an exchange of cash for illiquid bonds or shares the private sector would have more ‘liquidity’ and would therefore be better off. This would stimulate spending. By announcing that the central bank is prepared to engage in operations in formerly illiquid assets, these assets would themselves become more liquid. That would cause their prices to rise, make private sector holders of those assets better off, and increase demand. Higher levels of spending would raise expected inflation and lower real rates, stimulating demand further, and so on, until a point was reached when normal interest rate policy could be effective again.
Source: Bank of England Quarterly Review

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