More Banking Confusion: Liquidity Versus Solvency

Here is a choice quote from the recent EconTalk podcast with Anat Admati of Stanford University:

Well, they have fancy ways to talk about banks, and we try to unpack those. They talk about maturity transformation, liquidity transformation. What that means is really that the depositor, the people who lend to the banks, often time want their money quickly, especially demand deposits. But when they invest it, they kind of invest it longer term and in less liquid things. So there is a sort of imbalance between the money that they use to fund and their investment in the sense of the length of time until something has to happen and also the speed with which they have to pay versus get paid. And so that mismatch creates fragility by itself, which also means for example if all of us run to the bank at the same time then the bank may not be able to cover all of that. Even if it technically would be solvent, it has everything, that’s kind of an inefficient run that you could have, in principle. So basically the banks tend to run a little bit more than other people into liquidity problems. You could say that, just, I have the money but I didn’t go to the ATM kind of thing–I can pay you back but we’re going to have to find a liquidity solution, sort of a rolling back my debt. Their funding is kind of fragile almost by definition because of the way it comes and the way people can come back for their money on short notice or any time they want. So that’s part of the funding. And the investments are not as liquid or longer term than that. (emphasis added)

This is an utter confusion. This is not a “liquidity problem”, it’s a solvency problem.

Money-in-an-ATM is not the same economic good as money-in-my-hand. That is, money-five-minutes-from-now is not the same as money-right-now.

They are separate economic goods due to the time value of money. What Admati has done is create an arbitrary distinction between a future money good and a present money good, by projecting her preference/judgment onto an exchange involving two other parties of which she is not one.

If party A demanding “liquidity” from the bank B truly saw no difference between money-right-now and money-a-few-days-from-now, for example, then a bank run would never happen and these items would trade at the same price, which they do not.

This is a fundamental error of economic reasoning. I expect a professor of finance and economics to understand something like this and as a result I find myself disappointed to see that she does not.

Economists and politicians only let banks get away with this. If anyone else were to be so arbitrary and haughty toward contracts they’d be thrown in prison, but for banks insolvency never comes so long as you can contort logic to the point that you convince yourself that all that’s missing is a bit of liquidity.

This is more free lunch thinking.

Frank Shostak: Is Krugman Joking? Liquidity Traps Are Impossible

The Mises Institute’s Frank Shostak is out with another simple-yet-edifying piece on the “liquidity debate”, that is, is the US facing a liquidity or solvency crisis? Shostak argues that liquidity traps are impossible.

Shostak ranks with Gary North as one of the most accomplished observers of economic events through an Austrian lens, in my opinion. Here’s the salient snippet, though I recommend reading the whole piece:

To suggest then that people could have an unlimited demand for money (hoarding money) that supposedly leads to a liquidity trap, as popular thinking has it, would imply that no one would be exchanging goods.

Obviously, this is not a realistic proposition, given the fact that people require goods to support their lives and well-being. (Please note: people demand money not to accumulate indefinitely but to employ in exchange at some more or less definite point in the future).

Being the medium of exchange, money can only assist in exchanging the goods of one producer for the goods of another producer. The state of the demand for money cannot alter the amount of goods produced, that is, it cannot alter the so-called real economic growth. Likewise a change in the supply of money doesn’t have any power to grow the real economy.

Contrary to popular thinking we suggest that a liquidity trap does not emerge in response to consumers’ massive increases in the demand for money but comes as a result of very loose monetary policies, which inflict severe damage to the pool of real savings.