Vibrant, Highly Liquid Markets Are the Path to Prosperity
Last week in Washington, there were two committee hearings that discussed the diminishment of trading liquidity in U.S. capital and financial markets in the wake of the Dodd-Frank Act. One took place at the Commodity Futures Trading Commission's Market Risk Advisory Committee and the other took place at a House Agriculture Subcommittee. Both events featured testimony of the current diminishment in trading liquidity in a broad range of financial and risk hedging products. Both hearings raised the question of why should Americans care about reduced trading liquidity in U.S. financial and commodity markets.
Before answering that question, let me explain "liquidity." In essence, liquidity is the degree to which a financial instrument may be easily bought or sold with minimal price disturbance by ready and willing buyers and sellers. If you have ever held a garage sale, you know that there are more buyers interested in your costume jewelry than there is for that old violin left to you years ago by your late Uncle Alfred. The violin may have been appraised for $10,000 by his estate, yet the best offer you got during your garage sale is $800. The violin, while valuable, isn't very liquid. That is, you can't convert it to $10,000 very quickly or easily. On the other hand, the costume jewelry attracts many buyers and you sell all of it, making it a very liquid product.
To work efficiently, professional trading markets for products like natural gas, winter wheat and corporate bonds require sufficient levels of liquidity. That is, they require lots of willing buyers and sellers trading continuously in significant volume. Quantifying liquidity is challenging, but not impossible. It is more easily qualified through a range of characteristics such as market depth, width, volume, resiliency, immediacy, participation and turnover. Trading liquidity is the lifeblood of healthy markets. Today, it is widely apparent that many of these liquidity characteristics have been adversely changed in many instruments and markets.
Healthy trading liquidity is necessary for a return to true American prosperity - something we haven't seen in awhile. Within hours of the opening of last week's second hearing, the U.S. Bureau of Economic Analysis announced that the economy grew at an annualized rate of 0.5% in the first quarter of 2016, another milestone in the miserable economic expansion of the past decade. The average annual rate of GDP growth since World War II has been over 3.0%. Since the financial crisis, it has averaged about half of that. There is more than a coincidence between the weak U.S. economy and diminished American trading markets described at last week's hearings.
America's historic prosperity is built on numerous cornerstones, including its skilled workforce, strong productivity, natural resources, global trading prowess and technological and artistic innovation. It is also buttressed by the U.S. dollar's standing as the world's reserve currency for investment and international trade. Overseas investors have historically perceived our currency as the world's most stable for investment value and the most useful for global transactions. Many of the world's major commodities are priced in U.S. dollars, requiring foreign governments and investors to invest in dollar denominated holdings. Such foreign holdings drive demand for American Treasury securities and fixed income securities. They are an important source of debt capital for federal and state governments to afford infrastructure investments, health and welfare payments and pension obligations. In essence, the reserve currency status of the U.S. dollar underpins American prosperity, however now subdued.
The willingness of foreign governments and overseas investors to continue to place their capital in U.S. dollar holdings is predicated on US capital markets remaining the world's deepest and most liquid. Insufficient trading liquidity in markets for U.S. dollar denominated commodities, financial instruments and other assets cause overseas investors to fear that they cannot easily trade in and out of American investments as their domestic needs require. Insufficient trading liquidity adds risk to investors' investment strategies and the need to divert larger portions of their investment capital to assets denominated in other competing global currencies. In short, reduced trading liquidity in U.S. markets means less investment in our economy.
Some claim that healthy trading liquidity was underpriced before the financial crisis and should rightly be more elusive and costly today. Such arguments may appeal to well-financed market participants who can afford to pay increased costs for access to trading liquidity. Unfortunately, higher liquidity costs fall most heavily on smaller market participants like agricultural cooperatives and regional power utilities that must pass on the costs to farmers and consumers.
So, why should policy makers and market regulators care about increasing evidence of diminished trading liquidity in U.S. markets? The answer is simple: American prosperity. At our core, Americans have always been an aspirational people. We have always aspired to see our children succeed, prosper and do better than the previous generation. The "new mediocre" of slow growth economics and limited prosperity for a select few is unacceptable. Americans should demand a return to the broad based economic prosperity that for generations underpinned the "American way of life." An important step in regaining that prosperity is revitalizing liquid and vibrant American markets for capital, investment and risk hedging.
Why does trading liquidity matter? Because American prosperity matters; that's why.