Liquidity is a very important concept, including asset liquidity, market liquidity, institutional liquidity and economic liquidity.
First of all, the liquidity of an asset is the speed and ability of an asset to turn into cash. The most liquid asset is cash, which is stable, convenient and widely applicable. Illiquid assets, we call them fixed assets, or real assets, like houses.
Second, look at market liquidity.
The liquidity of the market depends on the amount of money versus the amount of assets.
The liquidity of assets and the liquidity of markets will affect the liquidity of institutions. Institutional liquidity refers to the flow of funds in and out of institutions.
Take the bank as an example. The entry of bank funds is the receipt of deposits, and the outflow of funds is the lending business. When the inflow of funds from banks does not keep up with the outflow, depositors may not be able to withdraw their money from banks. Let alone further borrowing. That's when you get a liquidity crisis.
The outbreak of liquidity crisis is generally closely related to the credit risk of banks. For example, if a bank lends money to 10 people, and if 6 of them don't pay back the money, it's hard for the bank to get the money back quickly.
At this time, if there are rumors outside that there is no money in the bank, people who have saved money may lose everything. Then depositors will panic and go to the bank to withdraw their money, leading to a real risk of bank failure.
The last and biggest dimension is economic liquidity, because the macro economy is supported by liquidity.
Macroeconomic liquidity is the amount of money that is being pumped into the economy. Currency issuance in countries is controlled by central banks, so when they throw money at the market, it pours into the market like flowing water.
Simply put, liquidity is the speed and quality of the realisation of assets;
Market liquidity is the embodiment of the enthusiasm of buyers and sellers, and institutional liquidity is the adequacy of institutional cash flow. The liquidity of the economy is how much money there is in the whole market.
Here's an example:
The liquidity of an asset is easy to understand. For example, if Jack urgently needs money but doesn't have much cash on hand, and he only has one house, does he need to sell the house for cash? Even if he finds a buyer quickly and goes through various procedures, there will still be a waiting period, and it will certainly not be a short time before he finally gets the money. Therefore, the liquidity of real estate is very low.
But if Jack had $100,000 in his stock account, he could just put money in, and it would come in very quickly. So there's a lot of liquidity in stocks.
Take the stock market for example. Market liquidity is the amount of money in the stock market, trading activity is not active. When the economy is good, a lot of people take money to invest in the stock market, so more money will be invested in the stock market. The market liquidity is good.
Institutional liquidity. We took the example of banks, but in fact, other institutions are also illiquid.
For example, a company wants to invest in a very good project, but the accounting finds that it has no money at hand. Then the enterprise will also face the problem of illiquidity. This is why we repeatedly emphasise the importance of corporate cash flow, which is covered in depth in our Introduction to the US Stock Financial Report For Beginners.
As for liquidity in the market, you may have seen the news headline "Central bank releases liquidity". Especially when the economy is bad, the central bank will lower the interest rate and release more money into the market, so as to facilitate the financing and investment of enterprises, stimulate consumption and stimulate economic recovery.
Let's expand it a little bit here.
Liquidity is one corner of Mundell's impossible triangle, along with profitability and safety. This model means that no single wealth management product can meet all three.
So, if someone recommends an investment product with "low risk, high yield, and high liquidity," this is unobtainable and you should not invest.
We may think that liquidity is a good thing. For example, if institutions lack liquidity, they will easily fail, and if they lack liquidity, they will find it difficult to liquidate quickly. However, too much liquidity in the economy is not necessarily a good thing. For example, excess liquidity will lead to inflation.
Therefore, the state usually keeps macroeconomic liquidity stable to facilitate the normal operation of the market.