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Beyond the Buzz

Learn About Liquidity

Stories about financial-market liquidity have been so ubiquitous that last year a Merrill Lynch analyst reportedly challenged his clients to go one week without mentioning the word.

Here’s an even more daunting challenge for buzz-spouting investors: define liquidity. Like many terms in the financial lexicon, liquidity is easy to quote but difficult to fathom. That’s unfortunate, since it may be the most important financial variable in keeping the economy and financial markets operating smoothly. Perhaps no factor will play a more important role in how your portfolio performs this year. 
With this in mind, we direct your attention to a transcript of a speech by Timothy F. Geithner, president of the Federal Reserve Bank of New York. In this role, Geithner is a permanent member of the Federal Open Market Committee, which meets every six weeks to set interest rates and other aspects of monetary policy.
Delivered in February 2007 (about seven months before the subprime liquidity crisis became apparent), the speech discusses various types of liquidity, how liquidity is measured and how monetary policy determines liquidity levels.
“Liquidity plays a critical role both in establishing the conditions that can lead to a financial shock and in determining whether that shock becomes acute, threatening broader damage to the functioning of financial and credit markets,” Geithner says. But then comes an important disclaimer: “We do not have, and probably never will have, a set of indicators that offers the promise of predicting when liquidity conditions will reverse, or when markets are particularly vulnerable to a more acute decline in liquidity.”
For more information about liquidity, check out an International Monetary Fund working paper by Abdourahmane Sarr and Tonny Lybek. The research, which can be downloaded as a PDF document, focuses on how liquidity levels affect asset prices. Although the IMF analysis is extremely arcane and somewhat dated — it was published in December 2002 — you don’t need to fully comprehend every concept to gain a better understanding of this important financial metric.
Since monetary policy is also something of a buzz phrase, many readers might benefit from a thorough explanation of the subject. Robert Schenk, a professor of economics at Saint Joseph’s College-Indiana, provides that and more at his CyberEconomics site. Schenk has published papers in a number of economic journals, including the Journal of Money, Credit, and Banking, and the Journal of Economic Education. Click on the Table of Contents at the homepage and then on Monetary History under Macro Selections to link to a comprehensive array of commentary. All the material is easily digestible and highly recommended. 
Finally, to put the subprime mortgage mess into historical context, visit Myvesta, a global not-for-profit organization that provides debt management counseling. At the homepage of the firm’s U.K. website is an overview of how credit began and evolved over the last 9,000 years. Click The History of Credit & Debt under Resources; the Online Exhibit link leads to seven relatively short but illuminating sections. 
The message here is that the extension of credit underpins both economic prosperity and decay, yet its proper rationing is as much art as science. And that should be the real buzz.

Thomas D. Saler is a free-lance financial journalist based in Madison, Wis.

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