The price of an asset is tautologically its liquidity, its “moneyness”. An asset may also possess other, usually lower, liquidity values – for example, those arising from its use as collateral security for advances. In recent times, secured borrowing in the banking system has increased remarkably; the financing of assets held.
Value and liquidity are not synonymous. The value of an asset to its owner may exceed its price; this is most often the case. Behavioural psychologists consistently report that the owners of assets require substantial premiums to part with mundane property such as coffee mugs.
Credit is an expectation of future liquidity. An advance is expected to be repaid by the debtor at some future times. It is well-defined and specific to that obligor. The terms may be enforced and collection assured by process of law.
The practice has developed of relying upon financial markets for future liquidity; a security bought in expectation of future sale. This future sale price is unknown and, arguably, unknowable. This difference in the source of future liquidity defines investment and speculation, and distinguishes between them. Investment might range from a government bill held to maturity to equity held solely for dividend collection. The returns depend only upon performance of the contract. By contrast, speculation relies upon sale at a market price. High frequency trading, with no interim cash-flows, is pure speculation. These are polar extremes with a continuum between them. This is directly related to the holding period. Even a bond held to maturity has a speculative element to it when coupons paid are reinvested through markets. Similarly, a long-held equity may have accumulated appreciable dividends relative to its market price, and with that, higher investment characteristics.
In this view, much of modern financial theory is better described as a theory of speculation rather than investment, and notably was in Bachelier’s “Theorie de la Speculation”. Certainly the “hedging” strategies of the Black-Scholes-Merton model may be categorised as speculative. Indeed, hedging against adverse price development in an asset is generically speculation.
The counterpart to both investment and speculation is saving, consumption deferred. For the individual this can be motivated in several ways, with different associated terms. Bequests for our children and successors have the term of our life-span, or simply for our next birthday party. Savings can have undefined term: ‘until we have enough to buy that Mercedes’, or be entirely precautionary – provision for the rainy day. Indeed, even the money in our pocket is a form of precautionary saving. It is our primary risk management tool. It facilitates exchange by resolving uncertainty, and admits the exploitation of specialisation in production and gains from trade.
These precautionary motivations are probabilistic in nature – we may never become ill, or unemployed, or suffer a flood or fire.
One of the few things we know with certainty about risk is that more things may happen than will happen. Institutions have been devised which exploit this property. Banks may undertake maturity transformation making long-term advances financed by precautionary call deposits. The insurance company may pool risks and offer cross-subsidy, lowering the savings costs of indemnifying the unfortunate. This is socially valuable finance. Investment capital demand from the private sector and public authorities may differ in term and amount markedly from that desired by individual savers. Indeed many individuals may wish to increase their current consumption at the expense of future.
Though unlimited in principle, such credit creation is limited by the stock of current wealth and that which may be created within the term of the advance. As recently as the 1970s it was not unusual for loans and bonds to be created which were amortising or self-liquidating – the project was expected to generate the cash-flow liquidity to service and repay the debt over its term. Indeed, in the 1920s, much government debt, particularly that issued internationally, had “earmarked” revenue streams, such as particular customs duties, to support it. This elementary view has been supplemented by the notion of ‘confidence’; the belief that the debtor may refinance debts to meet its then-current obligations. This is a form of speculation or reliance upon markets. The assumption is that at future dates, ever more remote production and wealth may be capitalised.
It is possible to think of perfect liquidity in these terms. Here the finance director may capitalise all future revenues at the ‘risk-free’ discount rate. This rate has been recently much-discussed as it was commonly proxied by government yields. It is subject to the technical condition to be a zero-coupon or discount rate; the absence of interim cash-flows ensures the arithmetic and geometric mean yields are congruent. It is simply a pure liquidity preference rate. Savers will accept a low rate only if future liquidity is expected to be high. When there is doubt over the future ability or willingness of a debtor to repay, higher rates will be demanded. This liquidity preference rate is the cost of liquidity – which must have a cost, even in this perfect world, since if it did not, all assets would be perfectly liquid.
This nirvana of perfect liquidity does not exist for many reasons – natural uncertainty is just one. Many future revenues may not be pledgeable. The separation of management from ownership, with the associated principal-agent problems is another. These frictions and costs may even be unobservable in the sense of future revenues foregone through management ‘shirking’. One possible interpretation of much of the academic ‘myopia’ literature, which finds that future income and gains are discounted at very high rates, is that these revenues are underestimated or disregarded by markets – in a sense, were unpledgeable.
Most corporate finance directors will concur in preferring to make a sequence of future payments over time rather than providing their present capital equivalent today. It may be that their cost of production of those future cash-flows is better than implied by the discount function, or that market liquidity imperfections mean that capital is unavailable to them equivalently.
One management response is to hoard liquidity; to maintain demand deposits, hold government bills, or negotiate lines of credit. These are usually short-term, high quality instruments; not subject to material price uncertainty over their remaining life, nor to substantial default likelihood. They are information-insensitive instruments. These instruments share the feature that their value as collateral is very close to their value in market sale – the haircuts applied in ‘repo’ are typically small. They are usually also eligible for discount or repo with the monetary authority.
With the central bank the ultimate insurer of liquidity for the banking system, as lender of last resort to solvent institutions, the pre-crisis absence of liquidity from banking regulation was theoretically justified.
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