Liquidity: Why So Important?

In recent days, the Federal Reserve, the European Central Bank, the Bank of Canada, the Bank of England, and the Swiss National Bank have teamed up to auction $110 billion off to world money markets in order to ease the recent liquidity crisis. But what is liquidity? Why should banks auction off money to deal with it? And how does inflation play into this phenomenon? Well, for starters, liquidity refers to the amount of money available in a given market that can be loaned from one entity to another. If an economy is looked at as a machine, with thousands of interconnected parts, then liquidity functions like oil, keeping all the moving components lubricated. If there is not enough liquidity in the market, loans become more expensive and time-consuming, and economic growth is inherently restricted because banks are less willing to lend to each other, in case they are unable to cover their deposits. The Northern Rock bank runs in England are a perfect example of what happens when a bank cannot make good on their deposits. In today's globalized economy, banks depend on lighting-fast transactions of large sums through all parts of the world. If they are wary of lending to each other, as recent events have shown, currency supplies start drying up. With this in mind, the sub-prime crisis of recent months seems poised to further restrict growth, especially in the US. The central bank's decision to add money into the economy is designed to keep cash-flow consistent in markets, which will also hopefully help boost investor confidence. Unfortunately, the sub-prime debt still exists, and banks are unlikely to lower the inter-bank borrowing rates much until all the debt is declared on balance sheets. And with 2 million more defaults likely to occur within the next year, the crisis is far from over. This injection of cash implies that central banks are trying to stem a problem they recognize to be quite severe, as they have never taken such concerted, coordinated action before. But their course will certainly impact the other primary concern, that which central banks must balance liquidity with: inflation. This refers to price increases, which make currencies less valuable. If it takes $10 tomorrow to buy a Big Mac, then the US dollar has lost about 40% of its value. By injecting a large amount of cash into the markets, the central banks know that they may pay a hefty price inflation-wise. When companies begin declaring year-end losses due to the sub-prime crisis, a more definitive judgment on the auction's impact on inflation can be made. By trimming interest rates in recent months, the Fed was hoping that consumer confidence and cheaper loans would be enough to jump-start the economy. While some confidence may have been restored, the diluted cuts, and especially the December quarter-point cut, have been criticized as underwhelming. If they had cut the rate 1% all at once, likely the outcome would be different. Only time will tell whether the huge cash injection will be enough to help banks lower their rates back to more growth-friendly levels.