Liquidity and Financial Crises
Liquidity is an elusive concept. On the one hand, an asset is liquid if it can be immediately exchanged for money without any significant change in price (a fire sale is not a manifestation of liquidity). Financial assets command a liquidity premium determined by their market relationship to cash. So liquidity is an adjective, not a noun. On the other hand, aggregate liquidity is often characterized as if it were a measurable quantity. Adrian and Shin (2008, p. 1) cite popular phrases such as “a flood of global liquidity” and “excess liquidity” as metaphors embodying this quantitative image. Liquidity is a noun.
It is this latter characterization of liquidity that is at the heart of financial turmoil. Adrian and Shin define aggregate liquidity as “the growth rate of financial intermediaries’ balance sheets,” and they relate that growth to the development of the repo market. This amounts to defining liquidity as “the ability of agents to command purchasing power by acquiring liquid liabilities,” an ability in turn dependent on the willingness of others to supply purchasing power against the issuance of liabilities. An economy “awash with liquidity” is then an economy in which the financial system becomes, as Shin argued in his Clarendon Lectures (2008), an “inflating balloon” looking for assets to fill up its expanding balance sheets. Conversely, that balloon may deflate when the ability to issue liabilities disappears and balance sheets shrink.
The history of financial bubbles (see Kindleberger and Aliber, 2005) demonstrates that all bubbles require two components: First, an asset or