Who Needs Liquidity?

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Lynn Stout writes,

Wall Street is providing far more liquidity (at a hefty price—remember that half-trillion-dollar payroll) than investors really need. Most of the money invested in stocks, bonds, and other securities comes from individuals who are saving for retirement, either by investing directly or through pension and mutual funds. These long-term investors don’t really need much liquidity, and they certainly don’t need a market where 165 percent of shares are bought and sold every year. They could get by with much less trading—and in fact, they did get by, quite happily. In 1976, when the transactions costs associated with buying and selling securities were much higher, fewer than 20 percent of equity shares changed hands every year. Yet no one was complaining in 1976 about any supposed lack of liquidity. Today we have nearly 10 times more trading, without any apparent benefit for anyone (other than Wall Street bankers and traders) from all that “liquidity.”

Pointer from Mark Thoma.

I was appalled by this paragraph (and by others in her essay), for a number of reasons.

1. It appears on a site calling itself “pro-market.” The conceit is that they are battling crony capitalism. However, the essay does not assert, much less establish, any connection between cronyism and trading volume.

2. Note that since 1976, some activities have been affected by the advent of a device known as the computer chip. The fact that we have nearly 10 times as much trading as then should be no shock. The cost of trading has likely fallen by way more than 10 times (feel free to compare brokerage charges adjusted for inflation). Who is Lynn Stout to suggest that the price elasticity of trading ought to be zero?

3. I would appreciate it if Lynn Stout could tell us how she thinks we should measure the benefit of liquidity. I believe that any thoughtful economist would say that this is a difficult issue. I have said that as individuals and nonfinancial firms we wish to hold liquid, riskless assets and issue risky, illiquid liabilities. Financial firms do the opposite. I am quite sure that this produces real benefits. But I would be hard pressed to arrive at even a conceptual approach to quantifying those benefits.

I believe that there is cronyism embedded in the relationship between Wall Street and Washington. But that does not justify pure demagogic bashing of investment bankers.

7 thoughts on “Who Needs Liquidity?”

  2. The suggestion that no one in 1976 had a problem with liquidity is staggering. In 1976, stock prices were quoted in EIGHTHS! That means that entering and liquidating a position entailed an unavoidable loss of 12.5 cents, maybe a quarter, PER SHARE. Plus commissions paid to stockbrokers (who were extremely rich people at the time). These are all, specifically and exactly, costs incurred because of the lack of liquidity.

    This is perhaps uncharitable, but you can see how the great communist disasters of the twentieth century arose from this kind of high-handed dismissal of what matters to ordinary people. Lynn Stout doesn’t care what is good for retail investors. If they got by on 1976 levels of liquidity back then, why should we waste our resources giving them more? And why should all that peasant labor be wasted producing food when they could get by on less and we could redeploy their manpower to produce glorious steel?

  5. In 1970s the average lifespan of a company in S&P 500 was 30 years or so. Technological and social change was slow and it did make a lot of sense to have long – perhaps several years – portfolio holding periods. Hence the number in the article – 20% of all shares traded annually back then.

    Things are different now. The average lifespan of an S&P 500 company is only 10 years or so. Technological and social change has accelerated immensely. Opportunities and industrial landscape change quickly as well. Shorter holding periods (and more trading as a result) make much more sense.

    When an asset manager (e.g. pension fund etc) decides to rebalance its portfolio all it needs is abundant liquidity at a reasonable price. That’s what Wall Street supplies.

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