Liquidity and Friction

A lot of people seem to believe that liquidity provided by the new fangled financial products like CDS, CDO, HFT etc is a good thing since it not only disperses risk but also provides liquidity to the system. Ms. McArdle of Atlantic Business is speaking for a lot of people when she says

What a transaction tax makes less profitable is a portfolio strategy that relies on lots of quick trades.  I suppose there’s a valid question about how much social value those folks provide, though you have to admit that they do at least increase the speed of the price information available in the markets, and to some extent their liquidity, which most people regard as a good thing. [Bold Mine]

However what excess liquidity does is that it increases the velocity of money, it’s the grease that reduces friction in financial transactions. Long ago when I first started studying Physics Friction was characterised as a necessary evil. A world where there was no friction is an uninhabitable world. Similarly when the excess liquidity reduces friction, it leads to inflation of asset prices.

We need to move to a world where there is greater friction in transactions by reducing liquidity as well as restricting the Velocity of Money in the Financial world.


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