Taxonomy of liquidity III: modeling liquidity

The fundamental problem that economics should seek to solve is what I will call the primary liquidity problem:

  • An individual, S, has a good that she wants to sell
  • There exists a buyer, XH, with the highest valuation, H, for the good
  • However, because finding XH is difficult, S may end up selling the good at a low valuation, L

The first task of economics is to organize trade in the economy so that every individual, S, can realize the high valuation, H, of that individual’s assets. Fundamentally the primary liquidity problem is a problem of trading across time and space. Note that the economic model of competitive equilibrium does not address this problem at all, but assumes it away, substituting for the primary liquidity problem the trope of the centralized market.

The primary liquidity problem can be addressed by borrowing. If S can borrow H, the value of the asset to XH until such time as S can find and trade with XH, then S will not sell at valuation L. Thus, there is a secondary liquidity problem, which only exists if there is a primary liquidity problem. This is the problem of borrowing the value of the asset until it can be sold.

Historically, banking developed to address the secondary liquidity problem. Banking in its 17th to 19th century origins developed to monetize the value of trade bills, where trade bills represent what in modern terms are called Accounts Receivable: a transaction has taken place, delivery has been made, and all that remains is for the buyer in the transaction to make the final payment. By standing ready to encash claims for payment held by sellers, the banking system provided traders with the time and space to locate their highest value counterparties.

Indeed, given the timing of the development of the competitive model in economics over the course of the late 18th and 19th centuries – in an environment where advances in banking had solved the secondary liquidity problem – there is every reason to believe that the competitive model could be conceived only after banking had developed and successfully addressed the primary liquidity problem. That is, the capacity to abstract from the primary liquidity problem was developed, because people were living in a world where bank credit made the primary liquidity problem irrelevant.

Note that there is a related, but in fact very different problem, which is the financing problem. Unlike the liquidity problem, which is a matter of realizing the highest value of a good that already exists, the financing problem is one of funding the development and production of a future good. While the ability to borrow against future income has implications for economic activity, this problem is of second-order importance to the primary problem of realizing the value of the goods that already exist. If the primary problem cannot be solved, then future incomes will be affected and have higher variability than when the primary problem can be solved. Thus, the financing problem is a tertiary problem, to be addressed only after the liquidity problem has been addressed.

Observe that in a post-banking world, the liquidity problem is often framed as a payments problem. A payments-type liquidity problem occurs when someone with an obligation to pay does not have the means to pay it. Note that payments-type liquidity problem can reflect either a primary liquidity problem, where the debtor is having difficulty realizing the value of the debtor’s assets, or a solvency problem, where the debtor does not have enough assets to pay the debt even when the assets are valued at their highest value. The concept of a solvency problem goes beyond the scope of this post, because instead of focusing on how to realize the value of individual assets, the solvency problem is evaluated at the level of the borrowing entity and requires a comprehensive examination of that entity’s assets and liabilities.

Bottom line: the competitive markets model should not be viewed as a model of the efficient allocation of resources, instead it should be viewed as a model that shows what happens when institutional factors exogenous to the model allocate resources efficiently (i.e. to their highest value use).

Last paragraph added 8-8-20

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