Liquidity is the amount of money that is readily available for investment and spending. It consists of cash, Treasury bills, notes, and bonds, and any other asset that can be sold quickly. Understanding liquidity and how the Federal Reserve manages it can help businesses and individuals project trends in the economy and stay on top of their finances.
Basics of Liquidity
High liquidity occurs when there an institution, business, or individual has enough assets to meet financial obligations. Low or tight liquidity is when cash is tied up in non-liquid assets, or when interest rates are high, since this makes it expensive to take out loans.
High liquidity also means there's a lot of financial capital. Financial capital, or wealth, or net worth is the difference between assets and liabilities. It measures the financial cushion available to an institution to absorb losses. Assets include both highly liquid assets, such as cash and credit, and non-liquid assets, including stocks, real estate, and high-interest loans.
As evidenced by the global financial crisis of 2008, banks historically fail when they lack liquidity, capital, or both. This is because banks can't remain solvent when they don't have enough liquidity to meet financial obligations or enough capital to absorb losses. For this reason, the Federal Reserve has tried to boost liquidity and capital at banks since the global financial crisis.
How the Fed Manages Liquidity
The Federal Reserve affects liquidity through monetary policy. Since the money supply is a reflection of liquidity, the Fed monitors the growth of the money supply, which consists of different components, such as M1 and M2. M1 includes current held by the public, traveler's checks, and other deposits you can write a check against. M2 includes M1 and savings and time deposits.
Moreover, the Fed guides short-term interest rates with the federal funds rate and uses open market operations to affect long-term Treasury bond yields. During the global financial crisis, it created massive amounts of liquidity through an economic stimulus program known as quantitative easing. Through the program, the Fed injected $4 trillion into the economy by buying bank securities, such as Treasury notes.
Lower interest rates bolster capital and reduce the risk of borrowing because the return only has to be higher than the interest rate. That makes more investments look good. In this way, liquidity creates economic growth.
When there is high liquidity, and hence, a lot of capital, there can sometimes be too much capital looking for too few investments. This can lead to a liquidity glut—when savings exceeds the desired investment. A glut can, in turn, lead to inflation. As cheap money chases fewer and fewer profitable investments, the prices of those assets increase, be they houses, gold, or high-tech companies.
That leads to a phenomenon known as "irrational exuberance," meaning that investors flock to a particular asset class under the assumption that the prices will rise. Everyone wants to buy so they don't miss out on tomorrow's profit. In the process, they create an asset bubble.
Eventually, a liquidity glut means more of this capital becomes invested in bad projects. As the ventures go defunct and don't pay out their promised return, investors are left holding worthless assets. Panic ensues, resulting in a withdrawal of investment money. Prices plummet, as investors scramble madly to sell before prices drop further. That's what happened with mortgage-backed securities during the subprime mortgage crisis.
This phase of the business cycle is called an economic contraction, and it usually leads to a recession.
Constrained liquidity is the opposite of a liquidity glut. It means there isn't a lot of capital available, or that it's expensive, usually as a result of high-interest rates. It can also happen when banks and other lenders are hesitant about making loans. Banks become risk-averse when they already have a lot of bad loans on their books.
Some economists cite the liquidity glut as the driver of the housing and lending boom that triggered the global financial crisis, while others pin it on the dramatic growth of the balance sheets of banks in response to the glut.
By definition, a liquidity trap is when the demand for more money absorbs increases in the money supply. It usually occurs when the Fed's monetary policy doesn't create more capital—for example, after a recession. Families and businesses are afraid to spend no matter how much credit is available.
Workers worry they'll lose their jobs, or that they can't get a decent job. They hoard their income, pay off debts, and save instead of spending. Businesses fear demand will drop even more, so they don't hire or invest in expansion. Banks hoard cash to write off bad loans and become even less likely to lend.
Deflation encourages them to wait for prices to fall further before spending. As this vicious cycle continues spiraling downward, the economy is caught in a liquidity trap.
In investments, the definition of liquidity is how quickly an asset can be sold for cash. After the global financial crisis, homeowners found out that houses, an asset with limited liquidity, had lost liquidity. Home prices often fell below the mortgage owed. Many owners had to foreclose on their homes, losing all their investment. During the depths of the recession, some homeowners found that they couldn't sell their homes for any amount of money.
Stocks are more liquid than real estate. If a stock becomes worth less than you paid, and you sell it, you could deduct the loss on your taxes. Furthermore, another investor will readily buy it, even if it's only pennies on the dollar.
Businesses use liquidity ratios to assess their liquidity and thereby measure their financial health. The three most important ratios include:
- Current Ratio: This amounts to a company's current assets divided by its current liabilities. It determines whether a company can pay off all its short-term debt with the money received from selling its assets.
- Quick Ratio: This is similar to the current ratio, but it only uses cash, accounts receivable, and stocks/bonds as assets. The company can't include any inventory or prepaid expenses that can't be quickly sold. Thus, it amounts to total assets less inventory divided by liabilities.
- Cash Ratio: As the name implies, this ratio amounts to cash divided by current liabilities. It's helpful when a company can only use its cash to pay off its debt. If the cash ratio is one or greater, the business has plenty of liquidity and likely will have no problem paying its debt.