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Wednesday, July 18, 2007

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.

    Posted by on Wednesday, July 18, 2007 at 12:15 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (17)


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