Sunday, 27 July 2014

Making Sense of Liquidity Preference

Philip Pilkington has a post on liquidity preference.

I've never liked the textbook version of liquidity preference.  This has the interest rate as being determined through the choice of investors between bonds and money.  It kind of makes sense if you imagine a world with only interest bearing bonds and non-interest bearing money, but it's harder to interpret when you want to factor in banks and bank money, which generally pay some form of interest.

In Pilkington's version, instead of money we take the collection of assets that serve as cash equivalents, e.g. short-term deposits, Treasury bills, money market fund shares, reverse repo, etc.  These will generally be interest bearing and although the individual rates will differ, we can take a single short rate as representative of the return on these assets.  On the other side we have longer term financial assets including government and corporate bonds.  Again, we can take some long term rate as representative of the interest rate on this class of asset.

We thus have two asset classes and two representative interest rates.  Changes in demand (and supply) between the two asset classes can then be invoked to explain, not the absolute level of rates, but the relative rates.  In particular, we can take the short rate as being set by central bank policy, and then take the long rate as being determined by relative demand and supply for short and long assets.  Since the collection of short term assets are often described as being a kind of liquidity pool, we can think of the relative demand for short versus long assets as being a matter of liquidity preference.

This formulation makes more sense to me.  However, whilst it may be useful to understand what drives markets, as economists we may be more concerned with how this might impact on actual demand in the real economy.  When looking at how financial shocks feed through the system, there may be more going on than can be easily described in this model.  Some points are worth making.

Long term interest rates on corporate debt might matter, but they're not the be-all-and-end all.  It may be that the short term rate has a greater impact on real activity.  And, although that may include expectations of future short rates, we need to avoid confusing what causes changes in the long rate.  A change in the long rate due to a change in preference for long-dated assets is not necessarily the same as a change due to a change in expectations about future short rates.
We have to be careful talking about liquidity as the term is not used consistently or, at least, there are different forms of liquidity.  So whilst it can be useful, in a certain context, to think of short term assets as representing liquidity and longer ones as not, that's not always the way it breaks down.  More commonly, the liquidity of an asset is defined as the ease with which it can be sold without affecting the price.  By this measure, long dated government bonds may be more liquid than short-dated corporate obligations (they are treated as such for the purposes of the BIS Liquidity Coverage Ratio).

The divergence between short term rates and long term corporate debt rates reflects a number of things, including the term structure of interest rates and credit spreads, as well as the actual liquidity of the asset.  These do not necessarily move in the same direction, nor do they necessarily have the same impact on demand.   

The causal chain from financial market movements to spending is not only about interest rates.  Financial frictions and institutional structure mean that quantity constraints may be more important.  Lenders may partially respond to changes in funding cost by adjusting their credit criteria, thereby mitigating the effect on lending rates.

In general, we have a whole range of financial assets, each carrying different elements of term structure, credit risk and liquidity.  In addition, we have a variety of financial institutions with different regulatory and commercial structures, which also face certain financial frictions, preventing instant adjustment to new equilibriums.  Sometimes, dividing assets into two distinct classes to illustrate liquidity preference is a useful exercise and can help explain things we see going on.  Sometimes, it's more complicated and simply looking at two classes of asset is inadequate.  In my view, much of what happened in the crisis is difficult to explain purely within the terms of a liquidity preference model.  Either way, understanding the structure of interest rates as the result of demand and supply pressures for different types of asset provides a useful framework for this sort of issue.


  1. When I started my career, I worked at an economic consultancy. We had a model in which the term premium was labelled the liquidity premium, in honour of Keynes.

    This usage confused our readers, and stopped making sense completely when 10-year on-the-run notes traded at lower yields than old 9-year bonds during the LTCM crisis. Everyone referred to the premium in the benchmark as a "liquidity premium".

    We re-calibrated the model, and we dropped the "liquidity premium" for "term premium", falling into line with modern usage.

    The problem with fixating what Keynes meant is that modern finance has spent a lot of time on these concepts, and has developed a more precise language. Economic models often have a deficient modelling of finance (for example, if a term premium exists, the inter-temporal governmental budgetary constraint breaks down), and possibly could use some of Keynes' imsights. But the terminology probably needs to come from finance.

    1. I agree. I think Keynes was a brilliant economist, but trying to shoehorn everything into what he may or may not have meant is silly.

  2. Hi Nick.
    A bit off subject but you might be able to point me in the right direction.
    I've been laying out G & L's model GROWTH in excel with some minor changes to avoid circular references and I'm having problems getting a steady state. I can get it with negative loans for firms resulting in too many bills for banks and a misleading government debt which is supplying those bills on demand but I'd obviously like to get a realistic outcome for all variables before shocking the model.
    The book doesn't lay out initial values for all the propensities and exogenous variables. Do you know where I might obtain starting values for these that give a sensible outcome ?
    Don't worry if not. I'm just being a bit lazy

    1. Sorry, I can't really help you there - I've not set up those actual models myself. Can you perhaps just tinker with the parameters until you get a more realistic steady state? Maybe you've already tried that.

  3. This comment has been removed by the author.

  4. It looks to me that your discussion is primarily from the perspective of the lender or investor. Is the perspective of the BORROWER the same? I think not.

    Why would the borrower be willing to pay more for some classes of assets? I think it has to do with both the desire to maintain control of assets and the ABILITY to maintain control.

    Examples will serve well to illustrate the concepts here. Corporate bonds can easily be retired but to do so would require giving up control of the property purchased with the bond money. With bond retirement, relinquishment of corporate property would be accompanied by relinquishment of corporate jobs and income. If interest is considered as rent on property and rent on job security, then interest on long term bonds is more valuable than interest on short term bonds because of the security offered by long term bonds.

    Consumer lending is divided between short term credit demands and the long term ability to pay. Products that rapidly depreciate have higher interest rates than do products such as houses that depreciate over much longer periods of time. This characteristic is inverse to the liquidity preferences of corporations.

    Government bonds are another financial species cogent here. MMT advocates point out that government does not need to borrow because it can simply print money as needed. In the real world, governments borrow extensively. Why this divergence between theory and reality?

    Governments are not borrowing for purposes of control of property in the same manner as corporate borrowing. It seems to me that governments are borrowing to protect the value of money. Government borrows so that the owners of money DO NOT spend the money. Government borrows so that government can spend the money, thereby controlling economic activity in proportions and directions preferred by government. The interest rates paid by government simply reflect the balance needed to ration money between owner spending, corporate funding, and the willingness to directly increase the money supply.

    Following this view, continual (that is year after year) borrowing by government can be seen as a continual strengthening of those entities that lend to government. Borrowing by government from the same entities year after year results in greater and greater control (through the financial process) passing to the favored entities. This is good for the favored entities but may be long term undesirable for the not-favored portion of the economy.

    1. Roger,

      Good points there.

      The conditions of the debt will certainly matter to the borrower, just as it will to the lender. The borrower will want longer term debt and the lender will want shorter term. So there is a demand an supply for tenor, if you like, and a corresponding price for it.

      As a borrower, the government (assuming a sovereign currency) might be seen as an exception. The government faces no liquidity constraint, so it should not care whether it borrows long or short.

      And it can be useful to think of the purpose of government borrowing (as opposed to just printing money) as to raise interest rates to encourage the private sector to save.