BizJournals Portfolio
Oct 16 2007 12:00am EDT

Liquidity and Information

The annoyingly anonymous WSJ economics blog (one assumes it's Greg Ip, but can never be sure) talked to Richmond Fed president Jeffrey Lacker yesterday, and asked him about this year's Nobel Prize in Economics. In response, he made an interesting distinction:

Mr. Lacker says mechanism design theory suggests “it’s not clear that liquidity was an important constraint” in causing the recent turmoil in financial markets. Rather, it suggests that the problem was more a shortage of information, a conclusion he deemed “consistent with the lack of use we’ve seen in the discount window,” the way the Fed lends directly to bank.

Now Lacker can say this partly because there's no consensus on what exactly this curious animal called "liquidity" really is. In a narrow sense, it just means "cash" – and so yes, if an absence of liquidity is just the failure of banks to be able to borrow cash at any interest rate, then what we saw this summer was not a liquidity crisis. (Quite the opposite, in fact: the Fed funds rate dropped all the way to zero more than once.)

On the other hand, it's fair to say that all markets are markets in information, and that a shortage of information really is a shortage of liquidity in the sense that liquidity is whatever it is that lubricates markets and makes them transparent and efficient.

Now cutting overnight interest rates is not going to magically inject more information into the system: the idea is that it's more of a signal to the markets, and an attempt to strengthen that diaphanous creature known as "confidence". It is these second-order effects of rate cuts which are always, in the short term, much more important than the first-order effects on narrowly-defined liquidity.


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