Liquidity as an illusion

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Comments on market liquidity by Keynes taken from Pimco’s Paul McCulley, “The Paradox of Deleveraging will be Broken”.

I will not present the McCulley argument other than to say that liquidity or the assumption of liquidity will be the number one issue for investment management in 2009. Every investment idea will be placed under the microscope of whether there is liquidity and what will be the exit strategy. This will mean that all strategies with less liquidity will have larger risk premiums and will provide greater opportunities for those that do not need immediacy. Additionally, there will be more focus on the exit strategy. The discussion of any idea will revolve as much around how do you get out as how or why you get in.

"The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment.

"For the fact that each individual investor flatters himself that his commitment is 'liquid' (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma.

"So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organizing markets wherein these assets can be easily realized for money."

The paradox of liquidity is that everyone cannot have liquidity at the same time, so there is no such thing as liquidity for the economy as a whole. You only have liquidity for those things that others want, so liquidity is only given to those who are contrarians. Nothing will be attractive except for those investments which the buyer has a comparative advantage relative to the rest of the market and those are usually few and far between.