WHAT IS A LIQUIDITY CRISIS?

WHAT IS A LIQUIDITY CRISIS?

by Frank Givens

What is a liquidity crisis? First of all, I don’t think all this up. It is an accumulation of ideas that have come my way. This particular subject is well documented in financial and economic journals. A liquidity crisis is a period of de-leveraging. It is when money and credit are in short supply.

Institutions like banks and investment companies (mutual funds) dump stocks wholesale to satisfy withdrawals. It is a time when fear grips business and industry. “Liquidity” is the capacity to turn assets into cash, or the assets in a portfolio that have the capacity to be converted to cash. Cash itself (i.e. money) is “The” liquid asset. Cash becomes king!

Debt of course eats liquidity. Borrowers can be characterized in three ways. There are those who can pay their debts from income. There are those who rely upon increasing values to satisfy debts. There are those who rely upon rolling debt and lower interest rates to satisfy debts.

These are the kind of economic times that our folks warned us would come. They may not have been familiar with the terminology, but price rations the available resources. Price is the fulcrum between supply and demand. In this present phase of the economic cycle, demand is fueled by liquidity, not speculation.

I’ve been reading a classic in economics, Manias, Panics, and Crashes by Charles Kindleberger. Our current situation falls into a well worn pattern that Kindleberger terms a “hardy perennial”. (It also demonstrates, in my opinion, that social engineering does not cure the evils of capitalism).

The cycle goes something like this: Profit is the incentive that fuels/creates economic expansion. In the pursuit of profit, we become dissatisfied with “small gains.” Increasing prices entice investment. Speculation leads away from rational behavior. Making money never seemed easier. A follow the leader process develops. Banks make riskier investments in this more optimistic climate. Easy credit fuels the fire of speculation. Everyone wants a piece of the action.

Individuals and business ignore evidence that it would prefer not to think about. Consciousness is repressed (modern economists call it cognitive-dissonance). Eventually this mania gives way to reality. A “displacement” like a surge in oil prices changes expectations. The cycle continues and the party always comes to an end! Good times give way to panic and then the markets crash! We have a liquidity crisis. Those who can pay their debts are separated from those who can’t. Asset values slide to equilibrium, often overcorrecting. And the process starts over!

The risk today is that fiat money (bailouts) will distort incentives to produce. But that is in the future and is a whole other economic story.

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Frank Givens, CPA, is a partner in the firm F.O. Givens & Co. in Senatobia, Miss. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Frank can be reached at 662-562-6721.