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Market liquidity and money liquidity, part II

Yesterday, in "Market liquidity and money liquidity", we talked about liquidity in the markets and the difference between market liquidity and "money liquidity", the money and credit created by the banking system and central banks.

Today, as we look at the relationship between money liquidity and asset and investment prices, both sides of the liquidity coin are in the news.

Market liquidity has come into focus with credit markets witnessing an "evaporation of liquidity" as the subprime fallout goes global.

Meanwhile, money liquidity has entered the story as investors debate the responses taken by leading central banks in their approach to recent market turmoil.

Here's the latest from CNN Money, "U.S. Stocks Slide As Subprime Woes Go Global":

French banking group BNP Paribas said Thursday that it has suspended three funds with exposure to the U.S. credit markets as it has become impossible to accurately value them after "the complete evaporation of liquidity."

Following the news, the European Central Bank said it allocated 94.841 billion euros, or about $131 billion, to 49 bidders in a one day quick tender at 4.0% to add liquidity to the money markets, a step the ECB has not made since 2001.

As part of its weekly open-market action, the Federal Reserve added another $ 12 billion in temporary reserves to the banking system through 14-day repurchases, double the amount added the prior week. The figure is "well within the norms of overnight injections, but a little less than what we had expected," said analysts at Action Economics.

The ECB and Fed moves came two days after the Federal Open Market Committee opted to sit tight on interest rates and retain its focus on inflation, while acknowledging there were risks from the recent turmoil in financial markets.

There is, of course, a full range of debate over what the central banks should or should not have done in response to this spreading panic. These arguments are not relevant for our purposes here. What is important is the idea that liquidity, in the form of money and credit created by the banking system, is needed to drive investment markets higher or help prop them up in times of panic.

But will an infusion of liquidity work to send investment markets higher or, in the midst of a panic, soften their decline? This is a question I find interesting, so I did a little reading on this and here's some of what I've found. You won't have to rely on my opinion on these matters, which is good news for all of us!

In the May 2005 article, "Is There a 'New Economy'?", Marc Faber pointed out that excessive money supply growth can lead to inflation in asset prices. He also mentioned an indicator called FRODOR (which stands for "Foreign official dollar reserves of central banks"), which was developed by Ed Yardeni and referred to by Marc as, "probably the best available measure of world liquidity".

I have not tested FRODOR's reliability as a forecasting tool, nor I am very familiar with this particular measure of liquidity. Still, it was an interesting item to come across, and I mention it in the hopes that a few readers will find some use for it. Plus, we now see that some investors are using this liquidity measure to help time their involvement in certain commodities and investments.

As for the relationship between money-supply growth and the direction of investment markets, Steve Saville points out that growth of money supply does not always translate into higher investment prices or market liquidity.

Here's how Saville put it back in March 2007.

The way we define the terms, there's a big difference between liquidity and money. This difference revolves around the fact that once money is borrowed into existence it remains in existence until/unless the debt is repaid*, whereas liquidity can disappear in an instant with no change in money supply.

For example, the rate of US money supply growth hit a multi-decade high in late-2001 and remained at a well-above-average level throughout 2002, but by the second half of 2002 the financial markets were suffering from a massive loss of liquidity. The rapid growth of the US money supply during 2001-2002 and the rapid growth of the global money supply during 2003-2006 ultimately led to substantial liquidity within the financial markets, but the point is that high money-supply growth can co-exist with low market liquidity for an inconveniently long period (inconveniently long, that is, for those who hope that surging money-supply growth will bail them out of the leveraged speculations they entered during the preceding boom times).

So far, it seems we've learned that an increase or decrease in the supply of money and credit can help drive certain investments and asset prices higher or lower over time. What remains uncertain is the timing of these relationships and the consistency with which they play out.

As if this was not enough to mull over, I should also point out that there are many recent discussions about the changing nature of "liquidity" and how it's created and defined.

As Axel Merk has pointed out, central banks may no longer be the dominant source of liquidity creation, in the sense of money and credit supply. According to Merk, leverage created through the financial markets now plays an important role in defining liquidity.

Doug Noland has also stated that "it is today a major mistake to associate 'money supply' with liquidity". As he wrote in his 2003 article, "Liquidity, Money, and Credit", "Liquidity and money have become distinct and are definitely not interchangeable".

I am also making my way through some similar arguments and discussion topics in the August 2007 edition of Marc Faber's Gloom Boom & Doom Report. I can only hope that I will be able to successfully digest some of this very interesting material.

For anyone who is still awake at this point, I hope this post and the two that preceded it have offered some small bit of insight into these topics. The nature of liquidity is still rather hard for many of us to define and pin down, but I hope you will find some illuminating thoughts in the articles I have linked here.

Hopefully, by examining some of these arguments, we will come a little bit closer to understanding the varying sides of the liquidity coin, as well as the effects liquidity has on investment and asset prices.

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