This “Liquidity” Demand That I Speak Of

I am over a week late, but Brad Delong writes

What Is This “Demand for Money” of Which You Speak?

If our big macroeconomic problem of deficient demand for currently-produced goods and services were the result of a deficient supply of liquid cash money–the stuff you keep in your pockets and use for clearing and functions as a medium of exchange–then the prices of all alternatives to money would be very low: people would be trying to dump their holdings of other assets to build up their stocks of liquid cash money, and only very low prices of and very high expected rates of return on those alternatives could check that desire. Thus we would expect a downturn caused by a shortage of liquid cash money to be accompanied by very high interest rates on, say, government bonds–which share the safety characteristics of money and serve also as savings vehicles to carry purchasing power forward into the future, but which are not liquid cash media of exchange.

I am sympathetic to Brad’s position. I think the focus on the medium-of-exchange can be excessive. The liquidity of an instrument – and thus how well it stands in for the medium-of-exchange – is a fluctuating quantity. For example, until Lehman crashed and Reserve Primary Fund broke the buck, Money Market Funds were very medium-of-exchangey. One can even use them to pay for stuff.

However, those check writing privileges don’t look so good when you are watching your account balance fall.

In addition my HELOC was source of liquidity. I wrote checks against it until late 2008 when watching the financial crises explode I decided that I needed to race against Wells Fargo’s legal team to cash-out into money before they cut the line.

Funds, Credit and Money are all forms of promises that are held in expectation of turning them into goods and services on demand. What I saw in 2008 was that the quality of some of these promises was deteriorating rapidly.  This is a de facto decline in the “Money Supply” even if those things aren’t actually cash.  The result was a scramble to replace lost liquidity that showed up even in the price of very safe assets. It also showed up in a decline of purchasing.

Here is the interest rate on 5 year Treasury Inflation Indexed Securities as well as Year-over-Year Retail Sales Growth (Inverted)

Throughout there is a weak correlation between the two, with the correlation tightening during the Fall collapse. This isn’t because people were running for pure safety. TIPS are about as safe as you can get. They were running towards liquidity, something that TIPS aren’t.

I would say that people wanted to keep their promises and were afraid that because Lehman couldn’t keep theirs the whole system of promise keeping was going to be screwed.