Is the World "Awash with Liquidity"?

Robert Shiller tries to understand what the current widespread use of the phrase "the world is awash with liquidity" signifies, and he concludes it may reflect worrisome market psychology:

'Awash in liquidity' suggests bubbly market, by Robert J. Shiller, Project Syndicate: We increasingly hear that "the world is awash with liquidity," and that this justifies expecting asset prices to continue rising. But what does such liquidity mean, and is there really reason to expect that it will sustain further increases in stock and real estate prices? ...

Traditionally, "awash with liquidity" would suggest that the world's central banks are expanding the money supply too much... But if that were the problem, one would cause all prices - including, say, clothing and haircuts - to rise. That is what ... Federal Reserve Chairman Arthur Burns meant when he said that the United States was "awash with liquidity" in 1971, a period when the concern was general inflation.

But the recent popular use of the term "awash with liquidity" dates to 2005, a time when many central banks were tightening monetary policy. In the US, the Fed was sharply raising rates. Central banks worldwide clearly have been behaving quite responsibly with regard to general inflation since 2005. ... So it is something of a puzzle why people started using the term so much in 2005. ...

Another interpretation is that people are saving a great deal, and that all this money is chasing investment assets, bidding up prices. Current Fed Chairman Ben Bernanke raised this idea a few years ago, alleging a world "saving glut."

But, once again, the data do not bear this out. The IMF's world saving rate has maintained a fairly consistent downward trend since the early 1970s... True, savings rates in emerging markets and oil-rich countries have been increasing since 1970, and especially in the last few years, but this has been offset by declining saving rates in advanced countries.

Another interpretation is that "awash with liquidity" merely means that interest rates are low. But interest rates have been increasing around the world since 2003. Hardly anyone was saying the world was "awash with liquidity" in 2003. The use of the term has grown in parallel with rising, not falling, interest rates.

Yet another theory is that changes in our ways of handling risk have reduced risk premia. ... But this is really a theory about risk management for certain kinds of products, not "liquidity" per se. ...

The term "awash with liquidity" was last in vogue just before the US stock market crash of October 19, 1987, the biggest one-day price drop in world history.

The reasons for that crash are complex, but, as I discovered in my questionnaire survey a week later, it would appear that people ultimately did not trust the market's level. As a result, they were interested in strategies ... that would allow them to exit the market fast.

The term "awash with liquidity" was also used often in 1999 and 2000, before the major peak in the stock market. So its popular use seems not to reflect anything we can put our finger on, but instead a general feeling that markets are bubbly and a lack of confidence in their levels.

Under this interpretation, the term's popularity is a source of concern: it may indicate a market psychology that could lead to downward volatility in prices.

Comments

[prostratedragon]

Well it does at least help one's faith in one's own equipment a bit to see Shiller having to dig down for some meaning to this "liquidity" the world is "awash" in

FWIW, I've gathered that some interpret the growth of debt and derivative assets in this country as evidence of liquidity, rather as if we were back in the 19th century when bank notes were effectively a negotiable medium. The large inflows due to the U.S. trade position and the interventions of the foreign central banks are often cited in relation to this view.

But, unless someone can show where they took their derivatives certificate down to the corner gas station or shopping mall and bought something with it, wouldn't this argument have to confront the same points that Shiller raises about interest rates and money supplies trending away from ease? (Of course, some who make this off-books monetary expansion argument are also suspicious of the lack of M3 data, so instead of negotiable bills those people would be arguing that we simply do not have an accurate picture of central bank activities.)

Goodness, when is it money and when is it not, I mean really, and not just in the M-definitions?

[billy]

But if that were the problem, one would cause all prices - including, say, clothing and haircuts - to rise..That is what ... Federal Reserve Chairman Arthur Burns meant when he said that the United States was "awash with liquidity" in 1971, a period when the concern was general inflation.

Why would it cause all prices to rise? That depends on where the liquidity ends up. If it ends up with those who already have enough, it gets spent on status goods - Picassos and yachts. Or it gets converted to stable low yield assets - like like land or plants - where control of the asset guarantees a steady return, and capital is preserved. A low yield on a large corpus is a huge income, and with control, its perfect for those who are not really worried about a haircut or shirt.

So the question is - do we see those things happening? Inflation in Picassos and yachts? Chasing low yields?

The faster economists can put the rational investor and human concept to rest, the better it is for mankind.

[KnotRP]

Is Shiller joking or is his mailbox nailed shut, thus preventing him
from seeing the deluge of offers to lend money at inexplicably
low (and sometimes zero) interest rates, to buy a $1M home, a
$100K car, or a $100 foot massage on credit with no payments
until ?

We are "awash in liqudity" because the cost of credit went soo
low as to be essentially zero for a very long period of time.
Don't you guys get out ever?

[spencer]

I have used the concept of economic liquidity since the 1970s to analyze the stock market. Stock market moves are driven by two things -- earnings and the PE, or valuation of earnings. I always treat the PE as an expression of the current value of a 7% perpetual growth in EPS. Over this period you could clearly see that the PE was largely a function of monetary policy and we used different measures of
monetary policy to capture the PE side of the stock market and called such measures economic liquidity. I even included foreign long and short rates in my measures of economic liquidity.

But my problem with this is that strong economic liquidity has always been associated with a rising stock market PE.
But this cycle I see everyone talking about strong economic liquidity in the face of a falling stock market PE.

So why is liqudity showing up as rising earnings rather than rising valuations this cycle?

[spencer]

P.S. My measures of economic liquidity were strongly negative in 1987 before the market crash.

[RN]

Spencer, that's a fantastic question.

[Ken Houghton]

Did you adjust for buybacks?

[SanFranciscoJim]

I think that what is happening is that the increasing wealth of the top tier is causing increasing amounts of money to flow into investment assets, be that real estate, the stock market or various complicated bond derivative markets.

This causes asset inflation and the sense that there is "too much money" floating around, hence awash in liquidity.

The things that middle income people buy, like food, clothes, cars, etc are not going up in price for the simple reason that middle incomes have not gone up.

[oops]

seems like the financial press is using the term rather loosley but there is a lot of cheap money out there via the yen carry trade but mostly this pool of liquidity just comes from corporate profits. strong cash flows everywhere and a lot of global growth. below is from morgan stanley's stephen raoch and a link to the entire article.

spencer- do you the think the rising E this time is due to profits going to stock buybacks?

Global
Labor versus Capital
Oct 23, 2006

Stephen S. Roach (New York)

What do the world’s three largest economies have in common? The answer underscores one of the key tensions of globalization -- unrelenting pressure on labor income. The corollary of that phenomenon is equally revealing -- ever-rising returns to the owners of capital....
http://www.morganstanley.com/views/gef/archive/2006/20061023-Mon.html

[spencer]

The divisor for the S&P 500 -- the adjustment for the change in the number of shares outstanding -- has been falling between 1% and 3% over the last few years so the change in buybacks does not seem large enough to account for much of the market rise.

[KnotRP]

oops -- that only works until the labor....uh....customer loses net worth and credit access.

[Lafayette]

Excerpt from the Morgan Stanley article "oops" cited (which can be accessed here):

The case of Europe merits special comment. We harbor the illusion that European workers are different -- that sheltered by a deeply entrenched social contract, they enjoy great success in getting more than their fair share of the pie. That impression is no longer accurate. As Elga Bartsch points out in a fascinating new piece of research, after having spiked up dramatically in the aftermath of German reunification, pan-European real compensation per employee has been basically unchanged since 2001 (see her 20 October dispatch, “Whither Euro Area Wages?”). Nor does she see this changing as an increasingly tight European labor market now approaches its “speed limit.” The structural forces are simply far too powerful -- namely, globalization, a shift to part-time and temporary employment, and the diminished power of European labor unions.

I think that about sums up the situation for the US as well. Unless Europe can find a way of pushing the magic button of productivity, it is possible that real income will stagnate.

And, if inflation relights, it's sure to happen. Which is why the BCE is likely to raise interest rates again before year end.

PS: Good article, "oops".

[real person from the real world]

I vote with SanFranciscoJim uptop. Those with too much are looking for a place to park their loot. Middle incomes are barely enough to live on, and don't have any discretionary spending available to stash away in assets.

[Lafayette]

The world is awash with liquidity largely due to undistributed corporate profits that a "parked" looking for returns.

When an economy picks up, they will be invested. For the moment, corporate Finance execs are looking for return anywhere globally they can. Which is why there is so much sloshing about. In fact, FDI in Europe has picked up along with the economy.

Go here to understand how the rich invest their fortunes.

NB: I saw a hint about where the world's money was. A Parisian "coutourier" (fashion designer) let drop the fact that the global market for very costly designer-dresses was not more than 700 women.

[Meh]

People aren't just suspicious of the lack of M3 data, there are those who are tracking unofficial measures of M3. Those unofficial estimates seem to show increasing money supply using the M3 measure.

[Brenda Rosser]

The neoliberal dream of unregulated financial markets and unregulated everything has meant the cooking of the books.

Watch out for fake credit ratings. Backdated stock options. Share buybacks. Falsified corporate reporting and accounts. short trading....anything along those lines.

Real wealth is food, shelter, cooperative and helpful communities, clean water....

Neoliberal economics is the ideology of greed. Pure and simple. Check other theorists out.

[reason]

I don't find the idea that any "liquidity" driving asset prices up will also fuel general inflation convincing. It depends who has it.

But I was under the impression that what was really being talked about was easy credit used for speculative investment. Total debt is skyrocketing, but like most people I have no idea just what means because each financial assets seems to be mortgaged several times to different people.

Just today I was amazed to get an e-mail offering me - no questions asked - $400,000 credit if I owned a property (any property). Wierd!