LIQUIDITY is everywhere. Depending on what you read, you may learn that the world's financial markets are awash with it, that there is a glut of it or even that there is a wall of it. But what exactly is it? Again depending on what you read, you may be told that “it is one of the most mentioned, but least understood, concepts in the financial market debate today” or that “there is rarely much clarity about what ‘buoyant liquidity' actually means.” An economics textbook may bring you clarity—or confusion. It is likely to define liquidity as the ease with which assets can be converted into money. Fine: but that is scarcely the stuff of dramatic metaphors. Liquidity thus defined is surely to be welcomed; floods, gluts and walls of water surely not.
Helpfully, Martin Barnes, of BCA Research, an economic research firm, has laid out three ways of looking at liquidity. The first has to do with overall monetary conditions: money supply, official interest rates and the price of credit. The second is the state of balance sheets—the share of money, or things that can be exchanged for it in a hurry, in the assets of firms, households and financial institutions. The third, financial-market liquidity, is close to the textbook definition: the ability to buy and sell securities without triggering big changes in prices.
When people worry about a glut of liquidity, they are thinking of the first of these concepts. If money is too abundant or too cheap, inflationary pressures may build up or bubbles may appear in financial markets—until central banks tighten policy or market opinion suddenly changes. A slackening of economic activity or a drop in asset prices can leave households, businesses and financial institutions in trouble if their balance sheets are not liquid enough (the second concept) or if they cannot find a buyer for assets (the third).
In principle, you can view the first concept through prices or quantities. Stephen Roach, of Morgan Stanley, suggests that for emerging markets, quantities (monetary aggregates, volumes of credit and foreign-exchange reserves) matter more; price signals (interest rates, credit spreads and so forth) are a better guide in developed economies, where capital markets are deeper and more liquid. In practice, it is usual to look at quantities.
Often, says Mr Barnes, it is assumed that the monetary environment is determined by central banks. But he thinks this too simplistic. Of course, by setting short-term interest rates they affect banks' reserves and lending, and the willingness of consumers and firms to spend or invest. They can still squeeze liquidity out of the economy, as the Federal Reserve did in the early 1980s, or create a deluge, as it did earlier in this decade. But America's bank reserves, at $47 billion, amount to only 6% of the country's monetary base and only 0.7% of the broad M2 measure of money supply. And the growth rates of both the monetary base and M2 have slowed in recent years, to below that of nominal GDP (see left-hand chart, above). From this, you might conclude that liquidity in America was not especially abundant.
However, that would be to ignore several important developments. A huge amount of credit is created outside banks and through clever instruments. Banks are increasingly able to securitise loans and get them off their balance sheets. The ratio of financial-sector to non-financial-sector debt, reckons Mr Barnes, has climbed from around 10% to 50% in the past 30 years. Financial innovation and deregulation have both helped these trends and aided international flows of credit. Looking at domestic numbers is no longer enough: you need to see the global picture.
Globally, money looks plentiful. In the euro area and Britain, broad money growth is running well ahead of nominal GDP. Or take the global supply of dollars, fuelled by America's large current-account deficit, the accumulation of reserves by foreign governments and their recycling back to the United States. A common measure of this, says Mr Barnes, is the American monetary base plus United States securities held by the Fed for foreign countries. Its annual growth rate peaked in 2004, at more than 20%. But because those securities have continued to pile up, this measure of liquidity is still growing at a rate of around 10% (see right-hand chart, above). Another gauge, combining all foreign-exchange reserves with America's monetary base, has risen at an average rate of perhaps 18% in the past four years. And this omits the contribution to global liquidity of the Bank of Japan, whose low interest rates are fuelling the “carry trade”.
All this is reflected in financial markets for everything from developing-country debt to corporate junk, commodities and art. Global willingness to save and lend is running ahead of investment. Ben Bernanke, chairman of the Fed, has spoken of a savings glut. Then again, the real puzzle could be companies' “investment restraint”, according to Raghuram Rajan, of the University of Chicago's business school (and until recently chief economist at the IMF). Maybe, he suggests, investment is becoming more centred on people and less on physical capital; maybe physical investment is being switched to emerging economies; maybe uncertainty still holds back investment abroad—as it does not, say, investment in property at home. Whatever the cause, a shortage of investment in fixed assets implies a shortage of debt collateralised on them. The financing glut has thus spilled over into markets for existing assets.
So what are central banks to do? Mr Rajan does not think that easy financing conditions can be laid mainly at their door. Still, he thinks that they may face an awkward dilemma. Tighter policy may push down long-term interest rates, boosting some asset markets further. Easier policy, however, would let inflationary pressures build. Mr Barnes concludes that it is too early to worry about liquidity: with inflation low, there is little prospect of a monetary squeeze; and American households and businesses' balance sheets (but not those of pension funds and mutual funds) are fairly liquid. Were there a market scare, he thinks, central banks would ease policy. One day, they may be tested.
This article appeared in the Finance & economics section of the print edition under the headline "A fluid concept"