Financial Market Liquidity Isn’t That Important for the Economy as a Whole

Photo Credit: Ricardinyo

Photo Credit: Ricardinyo || Secondary Markets are *not* the gears of the capitalist economy

Note to all of my readers before I start on my main topic: on the morning of 3/12 I give a talk to the American Association of Individual Investors in Baltimore.  If you want to see my slide deck, here it is.

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Okay, time for some secular economic and financial heresy, which is always somewhat fun.  Secondary market liquidity isn’t very important to the functioning of the general economy of the capitalist world, including the US.  (That said, my exceptions to this statement are listed here.)

Finance has an important role in the economy, aiding business in financing the assets of the corporation, and most of the value of that comes from the debt and/or equity financing in the primary markets, or from loan granted by a bank or another entity.

After the primary financing is done, the company has the cash to enter into its projects and produce value.  Then the stocks, occasionally bonds, and rarely bank loans issued trade on the secondary markets if they trade at all. That trading is:

The real action of value creation goes on in the companies — occasionally secondary market investing, through activists, M&A, etc., may find ways to realize the value, but the value was already created — the question was who would benefit from it — management or shareholders.

If you are investing, choosing assets to buy is the most important aspect of risk control.  Measure twice, cut once.  Yes, secondary trading may help you do better or worse, but only if the rest of the world takes up the slack, doing worse or better.  There is no net gain to the economy as a whole from trading.

I grew up as a portfolio manager for a life insurance company.  Many assets were totally illiquid — I could not sell them without extreme effort, and only interested parties might want to try, who knew as much or more than me.  Ordinary bonds were still largely illiquid — you *could* trade them, but it would cost you unless you were patient and clever.  In such an environment you made sure that all of your purchases were good from the start, because there was no guarantee that you could ever make a change at an attractive price.

My contention is that most if not all financial institutions could exist the same way, rarely trading, if they paid attention to their initial purchases, matched assets and liabilities, and did not buy marginal securities.  Now some trading will always be needed because individuals and institutions need to deploy new cash and raise new cash to meet expenditures.

But I would not give a lot of credence to those in the banks who complain that a lack of liquidity in the financial markets is harming the economy as a whole, and as such, we should loosen regulations on the banks.  After all, liquidity used to be a lot lower in the middle of the 20th century, and the economy was a lot more perky then.

Don’t let finance exaggerate its role in the economy.  Is it important?  Yes, but not as important as the financial needs of the clients that they serve.  Don’t let the tail wag the dog.