Saturday, 7 March 2009

The Liquidity Paradox

There is a very provocative piece from Willem Buiter's blog at the FT which stimulated me to post the following: does seem extraordinary that macro-economists, from what you have said, really have no adequate conceptual framework for explaining market liquidity and seem to just take it as a given in their modeling exercises. The paradox of liquidity is well expressed in the following quotation (which I believe comes from William Janeway)

Liquidity declines more than proportionally with the intensity of the demand for it. The more you need cash, the higher the price you have to pay to get it. And when average opinion comes to believe that average opinion will decide to turn assets into cash, then liquidity may be confidently expected to go to zero. By definition, no market can hedge this risk; no individual participant is rich enough not to need the hedge.

For me this has always suggested that no amount of sophisticated financial modeling will ever properly prepare and protect investors for the risks inherent in markets.

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