High liquidity means there is a lot of capital. That usually happens when interest rates are low, and so capital is easily available. Low interest rates mean credit is cheap, which reduces the risk of borrowing. That's because the return only has to be higher than the interest rate, so more investments look good. In this way, high liquidity spurs economic growth. The Federal Reserve manages liquidity by guiding the interest rate with monetary policy to set the target for the Fed funds rate.
A liquidity glut develops when there is too much capital looking for too few investments. This can lead to inflation. As cheap money chases fewer and fewer good investments, whether its houses, gold, or high tech companies, then the prices of those assets increase. This leads to "irrational exuberance." Investors only think that the prices will rise, and everyone wants to buy more now so they don't miss any profit.
Eventually, a liquidity glut means more of this capital becomes invested in bad projects. As the ventures go defunct and don't pay out their promised return, investors are left holding worthless assets. Panic ensues, resulting in a withdrawal of investment money. Prices plummet, as investors scramble madly to sell before prices drop further. This is what happened with mortgage-backed securities during the Subprime Mortgage Crisis. This phase of the business cycle, known as contraction, usually leads to a recession.
Constrained liquidity is the opposite of a liquidity glut. It means there isn't a lot of capital available, or that it's really expensive. It's usually a result of high interest rates. It can also happen when banks and other lenders are hesitant about making loans.Banks become risk-averse when they already have a lot of bad loans on their books.
Liquidity TrapAt the bottom of a recession, families and businesses are afraid to spend. They are afraid they'll lose their job, business will fall off, or they won't get loans needed to expand. If there is deflation, they might also wait for prices to fall further before spending. As people default on their debts, banks need to hoard cash to write down the bad loans. They become even less likely to lend. As this vicious cycle continues spiraling downward, the economy is caught in a liquidity trap.
Three things can get the economy out of a liquidity trap.
- First, prices can fall to such a low point that investors with enough cash start buying, knowing they can hold onto the asset long enough to outlast the slump. The future reward has become greater than the risk.
- Second, a government policy, such as increased defense spending or a interest rate cut, creates confidence that the government will support economic growth. This can work in a mild recession.
- Third, a financial innovation can create a totally new market. This happened with the internet boom in 1999.
Business LiquidityIn business and investments, liquidity is how easily an asset can be converted to cash. After the 2008 financial crisis, homeowners found out that houses had little liquidity. That's because the home price fell below the mortgage owed. Many owners had to allow the home to foreclose, losing all their investment.
Stocks are more liquid. At least if a stock becomes worth less than you paid, you could deduct the loss on your taxes. Furthermore, you can pretty much always find someone to buy it, even if it's only pennies on the dollar. During the depths of the recession, some homeowners found that they couldn't sell their home for any amount of money.
Businesses use liquidity ratios to measure their financial health. The three most important are:
- Current Ratio - the company's current assets divided by its current liabilities. It determines whether a company could pay off all its short-term debt with the money it got from selling its assets.
- Quick Ratio - The same as the current ratio, only using just cash, accounts receivable and stocks/bonds. The business can't count its inventory or prepaid expenses that can' be easily sold.
- Cash Ratio - Like the name implies, the company can only use it cash to pay off its debt. If the cash ratio is one or greater, that means the business will have no problem paying its debt, and has plenty of liquidity.