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Back to basis series (2) - Keynes liquidity dilemma

Posted on 16-Jul-2009

Financial markets play a key role to provide investors with liquidity and hence enable them to move capital from low-productive savings to highly-productive investments: schooling, training, research, innovation.

On the contrary, capital immobilization is a strong obstacle for investing in the real economy. Indeed nobody is willing to own a piece of a machine producing solar photovoltaic modules since it might not be easy to cash out part of this investment when needed. It is much easier to own a few shares of a listed company such as Applied Materials Inc (NASDAQ:AMAT) to contribute to green investments while being able to get back your money at any time provided that you accept an exposure to market risk and specific risks related to the company.

Hence liquidity is useful.

Yet it is somehow at this very precise point that liquidity becomes dangerous since it is a first transgression of reality: on one hand the real asset remains highly illiquid, and on the other hand, a liquid piece of paper is owned and traded in a financial world that can become a virtual world disconnected from the real world.

This is Keynes famous "Liquidity dilemma": liquidity is needed but too much liquidity can be a source of strong instabilities and destroy value because of its distance to reality and also because it enables contagion of fear from one asset class to another.

Hence liquidity must be monitored; rules and legal barriers must be reinforced to prevent contagions. The second Glass-Steagall Act, passed on 16 June 1933, and officially named the Banking Act of 1933 is a famous example of such anti-contagion rules.

In the nineteenth and early twentieth centuries, bankers and brokers were sometimes indistinguishable. Then, in the Great Depression after 1929, Congress examined the mixing of the “commercial” and “investment” banking industries that occurred in the 1920s. Hearings revealed conflicts of interest and fraud in some banking institutions’ securities activities. A formidable barrier to the mixing of these activities was then set up by the Glass Steagall Act.