Once again a misconception is gaining currency. There is increased talk of a build up of cash just waiting to be converted into equities or other assets. I wrote about this years ago in cash on the sidelines, but apparently the financial commentariat did not read the post, so it is time to revisit the subject.
I believe that the reason the misconception is so widespread is that the subject is not discussed in technical terms, but in metaphors. Some of you have heard the phrase “the great rotation”, which refers to the idea that investors will shift en masse from cash and bonds to shares. It’s a compelling phrase, but it leaves one question unanswered: who will sell the shares to these rotating investors and, given that these sellers will be paid for their shares, what happens to the money they receive? It’s still cash after all. Likewise, if these rotators are selling their bonds, someone has to buy them. Post-rotation, there is still just as much cash in the system and just as many bonds. Cash and bonds don’t just magically turn into shares. Reality is messy…why spoil a good metaphor?
A simpler, more dramatic and more vacuous metaphor that has also made a reappearance is the “wall of liquidity”.
No one using this compelling phrase would be so crass as to explain what it means. Such is its power, it is assumed that we all know what it means. So, let’s have a look at “wall of liquidity” out in the wild. In an article about rising bank share prices, Michael Bennet wrote in The Australian:
But pump-priming by global central banks has created a so-called wall of liquidity looking for income that is flowing out of cash and into high-dividend-paying stocks, with banks attractive due to their fully franked dividends.
Here it certainly sounds as though “wall of liquidity” is just “cash on the sidelines” in a fancy suit. But let’s zero in for a moment on the other metaphor in this sentence, “pump-priming”. Doubtless, the author has the US Federal Reserve (Fed) in mind. The standard line runs something like this: with low interest rates and purchases of securities through the “QE” (quantitative easing) programs, the Fed has flooded the banks with liquidity. More prosaically, reserve balances (i.e. the accounts banks have with the Fed) have grown. So far so good, as the chart below shows.
The next step in this line of thinking is that as this cash builds, it is a “wall of liquidity” desperate to find somewhere to go and, in the quest for investments, it will push up asset prices.
But before we can accept this reasoning, there is an important point to note. Reserves with the Fed are assets of banks only. Contrary to a common misconception, these reserves cannot be lent, they can only be shuffled around from bank to bank. Nevertheless, there is a theory that, because in the US and some other countries, a certain percentage of bank deposits must be backed by reserve balances, there is a “money multiplier” which determines a fixed relationship between reserve balances and bank deposits*. If this theory is correct, bank deposits should have grown as dramatically as reserve balances. They have not.
Taking the same chart and displaying it on a log scale shows that growth in deposit balances has been very steady over the last 20 years.
Whatever is going on in financial markets, it has nothing to do with a dramatic build up of cash which is poised to be converted into “risk assets”.
Yet another way to see this is to think about what is going on in Australian banks at the moment. Credit growth is slow in Australia. This is not because banks are reluctant to lend. Quite the contrary. Banks are looking at the slow credit growth and fretting about their ability to deliver the earnings growth that their shareholders have come to expect. The problem is that there is a lack of demand for credit as households and businesses continue to save and pay down debts. In response, banks have begun to compete aggressively on price and, in some cases, on terms to attempt to grow the size of their slice of a pie that is not growing. And yet these very same banks continue to compete for customer deposits. Australian banks are not sitting on vast cash reserves that are compelling them to lend. Rather it is simply renewed risk appetite that is driving banks to compete for lending.
The same is true around the world. Looking at cash balances as a sign that yields will fall and asset prices will rise is a pointless exercise. What is happening is much simpler. Animal spirits are emerging once more. Low interest rates (not cash balances) will help, but fundamentally it is risk appetite that drives markets.
The last time I heard people talking in terms of walls of liquidity was in 2005-2006 in the lead-up to the global financial crisis. These putative piles of cash were used to support a change of paradigm in which the returns for risk could stay low indefinitely. Of course this turned out to be dramatically wrong. The cash didn’t disappear, but risk appetite did. I am not predicting another crash yet, but I do foresee this nonsense being used to justify more risk-taking for lower returns. If that happens for long enough, then there will be another crash.
* As an aside, given that Australia has no minimum reserve requirements, if the money multiplier theory was valid, there should be an infinite amount of deposits in the Australian banking system. For the record, this is not the case.
Photo credit: AP
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Stubby,
I think these things can be made more formal and using Tobin’s asset allocation model and keeping track of each stock and flow, it can be shown (without any Monetarist behavioural assumption i.e., being perfectly aware about money endogeneity) that central bank asset purchases do indeed lead to stock market booms.
So while the notion “banks lend out reserves” in its raw form is incorrect, central bank asset purchases may still cause rise in stock prices.
Something like this:
The non-bank private sector allocates its wealth into various assets and with central bank purchasing government bonds, the non-bank private sector has less stock of bonds to allocate this wealth into. Of course the supply of equities is independent of central bank asset purchases in the first approximation, so the asset allocation equations lead to a higher clearing price of equities. And this is proportional to the amount of asset purchases by the central bank.
Going further, this also affects aggregate demand because a boom in equity prices leads to capital gains and because of wealth effect, people consume more. Again no Monetarist error.
Ben Bernanke has this transmission mechanism in mind. After having become the Fed Chairman, I have never seen him making a Monetarist error.
“the asset allocation equations lead to a higher clearing price of equities. ”
that assumes that demand for equities will go up, right? investors could instead be sated with the cash, without causing a rise in demand for equities. it also seems a bit irrational, as the price of equities should reflect business fundamentals, not an indiscriminate search for yield. that said, adding in behavioral assumptions, one can easily imagine this happening.
Just to reinforce Ramanan’s point, only 2% of US government debt is held by banks according to this source:
http://www.creditwritedowns.com/2011/09/holders-of-sovereign-debt.html
I.e. the effect of QE is almost entirely to increase cash holdings of various non-bank entities.
Non-bank agents that sell bonds to the Fed through QE end up with bank deposits earning practically no interest. It is likely that much of this money is then used to purchase other assets, including equities.
It’s slightly more complex than that because of the income side.
Government spending is removed from the private sector and either injected elsewhere or used to shrink the public sector injection.
Government policy as to what to do with the ‘saved interest’ similarly affects aggregate demand.
So you’re trading any potential wealth effect against an income effect.
There are two great research notes by Fed staff on this:
“Why Are Banks Holding So Many Excess Reserves?” and
“A Note on Bank Lending in Times of Large Bank Reserves”
Lets start with the second. It demonstrates with fairly straight forward math that the amount of excess reserves held by the US commercial banks is determined by the size of the Fed’s liquidity operations and signals nothing about its impact on lending and inflation. This is because banks receive an Interest on Excess Reserves (IOER) that is independent of the level of excess reserves. Banks decisions about what to do with $100 of excess reserves is the same as the decisions it would make if it had $1000000000 of excess reserves because it earns the same rate of interest on both. The paper does go on to suggest that excess reserves can in fact be contractionary in certain circumstances. But that’s not the argument being made and I will leave that to the interested reader.
SM has pointed out that the massive increase in reserves hasn’t filtered out into broader money supply figures. Why is this? The first paper argues convincingly that this is precisely because the IOER grinds the money multiplier process to halt. Traditionally IOER is zero. The banks have no incentive to keep ER on their balance sheets (it doesn’t earn any interest!) so they seek to lend it out in the short term interbank market to a bank that has some productive use for it (otherwise this other bank would not be demanding it) and in so doing expands broader money supply (increased loans / deposits). The expanded supply of interbank money also reduces short term rates. The extra deposits turn some of the excess reserves into required reserves and this process stops until either excess reserves are used up or short term rates hit zero. However because these crashing short term rates risked blowing up the money market fund industry in the US (which is big and important) the Fed started to pay banks to keep the reserves with it. This provides a floor for short term rates and because interbank rates are about the same as the IOER, the opportunity cost of lending interbank is zero and the money multiplier ground to a halt.
Now about the wall of liquidity causing a run up in asset prices. The reason why asset prices are rising is largely because people are re-rating their expectations of future income from these assets. As noted above it has nothing to do with central bank liquidity actions except to the extent these operations support other objectives of the central bank. And it is probably the latter which has driven asset prices recently.
The fed in particular has explicitly tied the stance of monetary policy to unemployment falling below a certain threshold and said they would be comfortable for inflation to be slightly higher than their target in the short term unless long term expectations are unmoored (A kind of qualified Krugmanian commitment to be reckless). The ECB, for all its inertia and incompetence, has ungummed some of the mess in the EU and the BOJ is about to appoint the most aggressive governor in recent history, not to mention the Bank of England being given a mandate that would allow it to be more accommodative. There’s a trend here. And note that it would be difficult to point to fiscal policy given the expectations of austerity to come.
It’s largely about expectations. They aren’t always right but people do make economic decisions now based on them. And right now it seems central banks are moving people’s expectations in the right directions.
wh10,
“that assumes that demand for equities will go up, right? investors could instead be sated with the cash, without causing a rise in demand for equities”
Yes assumes will go up.
It’s a bit like this. The asset demands for various assets in Tobin’s asset allocation equations – as is done for example in Godley/Lavoie depends on various things, such as the allocation parameters λs, interest rate on deposits on bills, expected return on bonds, equities etc. So a reduced supply of bonds than otherwise (with no QE) should lead to a reduction in long term yields than otherwise and increased demand for equities.
Equity prices needn’t reflect fundamentals -only for “fundamental analysts” it is so. Demand for assets also depend on relative attractiveness etc.
Ben Bernanke from Jackson Hole (quoting Tobin):
http://www.federalreserve.gov/newsevents/speech/bernanke20120831a.htm
@IC you are still thinking from the perspective of a single bank not the system. Even without the IOER, banks in aggregate could not reduce the size of reserves even if they wanted to. Any bank that lends reserves to another bank just moves the balance from one bank to another. The role of the IOER is not to control the aggregate balances of reserves but simply to sterilise the impact reserve balances have on short term interest rates.
Aggregate bank deposits (wholesale and retail) are driven by credit growth not by reserve balances. (The mix between wholesale and retail is a more complicated story).
“The cash didn’t disappear”
Maybe not, but its buying power sure did. That’s precisely the point you’re missing, Stubby. Financial assets are paper promises that can be created and destroyed at will (either by default or deflation). If one does the accounting only in nominal terms, locked away in the ivory towers of the financial economy, without linking them back to the real economy, there is no frame of reference to see the system’s absolute displacement. It all seems stationary… at least until relative financial prices seem to go out of whack. And they do because the financial economy is not a rigid body; when the credit universe expands, liquid assets rise first, illiquid ones second. Thus if credit accelerates rapidly, or the monetary base is subject to shifts of tectonic proportions (read QE), a tsunami of liquidity can indeed rise and, if the expansion holds, inundate asset markets.
This, of course, is no economic miracle; it is mere accounting trickery, as credit-fuelled cash inflation spills over to asset inflation, while real wealth remains constant, albeit more concentrated in the hands of those who’ve got rope to lend in the high tide, and deep pockets to pick up the empty shells when liquidity recedes.
@Wisdom Tooth in your terms, what exactly is this wall of liquidity? In what units is it measured? Are you referring to growing balances of something? Cash? A particular asset class? Or are you just referring, somewhat metaphorically, to an increased appetite for riskier assets?
If only the latter, then I am happy to agree. I should emphasis that I am not arguing that there can’t be big swings in pricing of different asset classes. That clearly can happen. There was enormous compression of spreads (increase in prices) in credit assets prior to the financial crisis and spreads have been contracting markedly again. These phenomena are real and can be distorting and dangerous. My point only is that these phenomena are not driven by a build of up cash (or something else) that is inexorably converted into risk assets. Rather, they are the result in the perceived balance of risk and reward: the higher return of risk assets starts to look increasingly attractive and (somewhat circularly) as prices rise, the risks they present appear to recede, particularly if investors came be convinced that a mystical “wall of liquidity” will continue to push prices up.
Australia is a good case in point. There is no build up of anything other than an increased competitiveness amongst banks, an increase in their risk appetite. It’s not that they have a pile of deposits they need to deploy, they are simply chasing returns and are less concerned about the risks than they were a couple of years ago.
@Ramanan with reference to your first comment, the argument seems to rest on relative supply of government bonds and equities. How do you deal with the possibility that much of the stock of the assets that the Fed has bought has come from bank balance sheets? From the point of the bank, there balance sheets have shifted from bonds to reserves, and banks would certainly not have been buying equities. Even where the bonds have been sourced from the non-bank sector, does the argument rely on the stock of bonds being relatively fixed? Along with the increase in risk appetite, bond markets have become more accessible for issuers (corporate bonds, mortgage-backed securities, etc).
I know you understand the monetary flows, so I’m not debating that point. What I’m saying here is that the real impact of QE is to keep longer-term rates down, pushing up the prices of longer term government bonds (and any other bonds within the scope of the QE program). On a relative value basis, this will tend to push up the prices of other fixed income securities with similar risk profiles. Issuers can take advantage of this in the primary market, expanding supply of these securities taking advantage of the higher prices in the form of lower borrowing rates.
Nothing like a juicy economic debate to sip over a balmy Saturday evening (:
> Are you referring to growing balances of something?
Most certainly.
“Cash? A particular asset class?”
Yes, paper assets; cash included.
In what units is it measured?”
On the Liability side of the Sheet, liquidity is defined by easiness of funding (versus easiness of transacting on the Asset side). Thus indicators of debt liquidity are credit volumes, credit rates (i.e. spreads), or – better yet – a combination thereof. No single accepted measure of liquidity exists in the academic literature, TTBOMK.
“Or are you just referring, somewhat metaphorically, to an increased appetite for riskier assets?”
Yes, I am referring to an increased appetite for riskier assets, but only insofar as illiquid assets are riskier. They are not because they are synonymous but because they are correlated (or cointegrated, whatever). Illiquid assets, by definition, sit in the outskirts of the market, and are thus more exposed to the fluctuations of credit tides than those sitting in the bottom of the liquid ocean (i.e. US Treasury Bills; in time: all prices are relative).
So it’s not decreased risk aversion that drives increased appetite for riskier assets; it’s liquidity spillover. No “animal spirits” either, I’m afraid; people’s behaviour towards risk – outside financial markets’ fairy tales – don’t change that much to justify financial volatility (do they engage in riskier sports, for instance?).
“What exactly is this wall of liquidity?”
Here: http://en.wikipedia.org/wiki/File:USDebt.png
“My point only is that these phenomena are not driven by a build of up cash (or something else) that is inexorably converted into risk assets. Rather, they are the result in the perceived balance of risk and reward: the higher return of risk assets starts to look increasingly attractive and (somewhat circularly) as prices rise, the risks they present appear to recede, particularly if investors came be convinced that a mystical “wall of liquidity” will continue to push prices up.”
Now the grand finale. This is exactly where I disagree with you, Stubby (and am glad it’s on your central thesis, and not a side issue or frugal technicality). Professional creditors and investors know the balance of risk and rewards, outside scenarios of war, natural disaster and disruptive technological change, don’t change that much. They are indeed right to believe that a “‘wall of liquidity’ will continue to push prices up”. This is so not because of “circular” reasoning or of “animal spirits”, but because liquidity itself is circular. Liquidity beckons liquidity, thus while professional investors do behave in herds, if there are animals in their spirits, they must be the coldest-blooded amongst us. The Nature of the Market selects them so.
Stubby @March 23, 2013 at 5:42 pm,
Good point.
The Federal Reserve buys the bonds from primary dealers true but these dealers are not the ultimate buyers of the bonds. They are intermediaries. The amount of bonds the Fed holds exceeds the amount banks would have held if there were no QE. Banks in the US generally hold less of government debt and more of MBSs. The Fed holds about $1.7tn of government bonds but would have held around $1tn otherwise so these are from non-banks. My point being that the purchases from the non-banking sector is higher compared to the banking sector although I will have to prove that point in detail.
It is true that lower yields would make issuers accessible (and hence I used the phrase – “in the first approximation” – in my original comment) and the supply would also increase in response. My argument is along the lines that the demand is shifted far more than the supply so that the clearing is more via higher price. This is because the supply will respond less to lower yields than to improved demand expectations of their/firms’ products.
Quite apart from the other problems, I don’t understand the “wall” bit. A bucket, an ocean or a wave, that would make sense, but how can one have a liquid wall?
@Danny Yee: where is your sense of drama? Think tsumami!
@stubbornmule
I think we agree that the amount of reserves in the system (required and excess) is determined purely by CB actions.
What I think you might be objecting to is my description of the money multiplier effect. I may not have been clear in describing it (as per the staff paper). I gave the example of a bank lending out its reserves to another bank that had some lending opportunities. I agree that the system wide reserves don’t change when this occurs. Unfortunately I was lazy and didn’t explicitly point out that those lending opportunity arose independently to the quantity of system reserves.
I was only trying to make the point that when this does occur (lending opportunity is actioned), excess reserves get turned into required reserves by that loan creating a deposit (in certain circumstances and until the o/n rate hits zero or ER don’t exist). The effect of IOER is, as you put it, to sterilise the impact of the reserve balances on o/n rates.
Of course there’s a separate question about what gave rise to those loan opportunities.
Some relevant data calculated by Citi and quoted here:
http://pragcap.com/the-short-supply-of-assets
Thanks Ramanan. To me, a story told in terms of shifting risk appetite preferences of different sectors (e.g. institutional investors) and inflow/outflow of supply of particular assets classes (e.g. highly rated bonds) makes for a far more convincing explanation of what is going on that simply saying “governments have been running the printing presses, so there’s a whole lot of money out there looking for a home”.