September 28th, 2009
06:14 AM GMT
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“My accountant says I did this at a very bad time. My stocks are down. I'm cash poor or something. I got no cash flow. I'm not liquid, something's not flowing.” - Isaac Davis in Woody Allen’s “Manhattan.”

There are a number of metaphors that can be used to describe liquidity in the financial markets. One is to think of every object of value – cash, stocks, houses, art – as pieces of ice, frozen in value. Its liquidity can be measured by its ability to melt and reconstitute itself in value while changing hands.

Cash is highly liquid, because there is little change in value when sold or exchanged – so it melts and freezes quite nicely. Rare objects of art are among the most illiquid – they are auctioned and transferred back into cash once every few decades.

A way I prefer to think of liquidity as is oil. What caused the global economy to sputter last year was the commercial paper market, a financial tool as mundane as the motor oil that sits in the engine pan of every automobile. Imagine, however, the oil in every car in the world suddenly drying up below manufacturer specifications – poorly maintained cars start choking, creating traffic jams worldwide. Even Ferraris begin to ping and rattle.

The commercial paper market keeps companies running day-to-day because a going concern’s accounts receivable rarely matches its accounts payable. Large companies regularly borrow millions for one-day, low-interest loans so they can, for example, make payroll while waiting for clients and customers’ checks to clear. When Lehman Brothers went bankrupt, however, the Reserve Money Fund – the market’s oldest money fund that is fed daily by the commercial paper – “broke the buck”. For the first time ever every dollar invested in the fund was worth only 97 cents.

When you hear about “the collapse of the world financial system,” this is the ground zero event. Investors in the traditionally safe fund suddenly run for cover, exacerbating the crisis. Well-run, profitable businesses with no connection to the subprime mortgage debacle suddenly face a liquidity crunch.

Like Isaac Davis in “Manhattan,” the world banking system found “something’s not flowing.” And many of the efforts of governments around the world are to keep the spigot going.

soundoff (5 Responses)
  1. varsha

    That's why a Government intervention is needed in such times to 'break the ice'!

    September 28, 2009 at 5:35 pm |
  2. Elvis

    All this injections and bail outs are not working,what i expect the global financial system to do is to see how they can correspondingly increase goods and services.there is liquidity in the system,only that they are in the informal sector.a well regulated economy will surely fairly circulate this liquidity.

    September 29, 2009 at 3:55 am |
  3. David Vanderpool

    I believe the banks are taking the massive government handouts they have collected and refusing to loan the money to individuals because they want to loan at much higher interest rates than they can justify when they are paying us just about nothing on our cash reserves. I am a capitalist, but the behavior of the banks has almost changed that. They need to be seriously checked and balanced by some sort of oversight. Now.

    September 29, 2009 at 5:00 am |
  4. Lim Boon Chuan

    I do not believe that the banks are holding back in anticipation of higher returns. They have to consider the risk factors. At this moment, the global economy's outlook is still extremely murky, risk dictates that higher interest rates have to prevail before the banks are willing to part with their cash.

    September 29, 2009 at 5:50 am |
  5. Baffled

    Is a company that regularly has to borrow to make payroll a well-run business? If a business is profitable shouldn't there be some reserves to draw upon? I can understand a new business being squeezed to make payroll – but Fortune 500 public corporations? Maybe they are trying to be a bit too clever with their finances.

    September 30, 2009 at 11:45 am |

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