Ebook The New Economics of Liquidity and Financial Frictions, by David Adler
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The New Economics of Liquidity and Financial Frictions, by David Adler
Ebook The New Economics of Liquidity and Financial Frictions, by David Adler
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The New Economics of Liquidity and Financial Frictions is a book about a new branch of economics that is largely a synthesis of macro and finance. In many ways, it is a radical departure from the older, frictionless approach still prevalent in economic textbooks and most of academia. This book provides a new understanding and approach to asset pricing, risk measurement and management, central banking policy, and the overall working of today’s economy, including questions of financial stability.
- Published on: 2015-01-08
- Released on: 2015-01-08
- Format: Kindle eBook
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Interesting Insights - Check out the Foreword - Is Money a Veil or a Lubricant?
By Bud Haslett, CFA
Thoroughly enjoyed this. Check out the Foreword for some insights.
Foreword
There cannot, in short, be a more insignificant thing, in the economy of
society, than money.
—John Stuart Mill, Principles of Political Economy with Some of Their
Applications to Social Philosophy
Feathers and Bricks
What would you think of a scientific field that assumes away one of the most basic
aspects of the natural world that the field hopes to understand? Probably not much.
Yet modern macroeconomics, astonishingly, assumes away the existence of money,
banking, and the rest of the financial sector. As a consequence, macroeconomists
didn’t foresee the great crash of 2008–2009 because the crash originated in the
financial sector, which, according to their predominant model, didn’t exist.
That’s not as crazy as it sounds. Newtonian and Einsteinian physics assume
that there’s no friction. Even Galileo, when he compared the speed of dropped
feathers and bricks a half century before Newton, knew to allow for friction
and concluded that gravity acted equally on the two objects, the difference in
their rate of fall being due entirely to resistance from the atmosphere.
A World without Friction
Why assume away something important, such as friction? Simplifying nature
in this way creates a base case from which deviations can be measured and
explained. Feathers encounter considerable friction. If we didn’t know the rate at
which bricks fall, we wouldn’t be able to measure the greater impact of friction
on feathers. Likewise, the economy is full of frictions: Search and transaction
costs prevent markets from being perfect or close to perfect, while decisions are
made using incomplete information by people who are less than wholly rational.
Macroeconomics, then, has evolved in a way that tends to set aside such
distractions as money and the financial sector because it seeks to explain, in as
simple terms as possible, the functioning of the real economy—the economy of
factories, trucks, natural resources, labor contracts, patents, and so forth. The
financial economy, from this viewpoint, is a sideshow involving claims on the
real economy—stocks, bonds, commodity futures contracts—but not the real
economic goods themselves.
Is Money a Veil or a Lubricant?
In this sense, “money is a veil,” as Arthur Pigou famously said, channeling
John Stuart Mill as quoted in the epigraph. (Pigou 1949; Mill 1848, moreover,
The New Economics of Liquidity and Financial Frictions was channeling
David Hume’s 1752 essay “Of Money.” Money as a veil is a
core concept of classical economics, but it has leaked through to Keynesian
economics too and is basically correct: Without money and finance, we’d have
a barter economy that would suffer from huge friction costs but that would not
otherwise be very different.) In other words, the use of money as a medium of
exchange obscures the real economic phenomena beneath. If that is the case,
let’s remove the veil and study the real economy.
But financial institutions and instruments do exist, creating and trading
them makes up a significant fraction of total economic activity, and they need
to be explained and understood. They are best understood as a form of infrastructure,
without which the rest of the economy would struggle to function.
A City without Water
In that sense, financial institutions are like water utilities. If you planned a city
without a water utility, you could assume one would spring up to fill the unmet
need. But you could make some spectacular mistakes, such as deciding that the
ideal place for the city—for other reasons—was on a mountaintop in the arid
state of Utah. A water utility will not “spring up” there. Likewise, if farmers
need to borrow to plant in the spring so they can harvest in the fall and repay
the loans, you could “assume a bank.” The need for a bank in such a situation is
so obvious that investors would be falling all over each other to establish one.
In a modern economy, which is much more complex than a farming economy,
the need for financial institutions is even greater, and the instruments
they use include equities, derivatives, and every manner of loan or bond. Yet
it’s still possible to model the economy without a financial sector, and in order
to pierce the monetary veil and see through to the real assets and transactions
behind it, macroeconomists have generally done so. For reasons of mathematical
tractability, their models—especially the so-called dynamic stochastic general
equilibrium (DSGE) models—have staying power.
But having assumed away the financial sector, DSGE models and their kin
did not and could not foresee the crash of 2008, nor did they even assess the
possibility of such a crash. They could not see that the mechanism that prevents
the economy from seizing up because of transaction costs (say, from having to
barter) might stop working from time to time and cease to provide capital—or,
in extremis, cash from ATMs. In the wake of the global financial crisis, it became
evident that macroeconomists needed a new kind of economic modeling that took
account of the need for liquidity and the existence of financial frictions.
Conventional financial economics, too, has been neglectful of the effects
of illiquidity on capital markets and on investor behavior. Most of modern
portfolio theory—and most empirical research in finance—assumes that one
can buy or sell as much of a security as one wants to at a price close to that
of the previous trade. When this condition fails to hold, markets can behave
in ways that classic portfolio theory does not predict. By adding illiquidity to
the bundle of characteristics or risks that investors must deal with, research in
finance moves closer to the real world and becomes more useful.
A New Economics That Addresses Liquidity and
Financial Frictions
At these points of inflection, where traditional economics and finance are joined
by the study of liquidity and other financial frictions, lie the new frontiers of
economics, as described in David Adler’s lucid book. In an unexpected marriage
of macroeconomics and finance, a group of pioneering researchers is creating
a new body of economic theory. This school of thought treats financial frictions,
including illiquidity, in the spirit that modern physics embraces when
it acknowledges the friction that causes feathers and bricks to fall at different
speeds. Adler, a nonfiction author (Adler 2009), reporter, and documentary
producer—who has already written a CFA Institute Research Foundation literature
review on this topic (Adler 2012)—now turns his attention to explaining,
in accessible language and without formulas, both the conceptual foundations
and the practical applications of this new turn in economics.
Adler’s exploration of the changes in economics wrought by the global
financial crisis and stock market crash is much more than a summary of new
theories. The research he describes has direct application to public policy. A new
word—“macroprudential”—describes policies, practices, and regulations that
are intended to protect the financial system and not just a particular financial
institution. A deep understanding of the concepts in this book is necessary for
deciding what macroprudential policies to implement.
Investors, too, benefit from knowing what policymakers, financial institution
executives, and economic researchers are learning about liquidity and
financial frictions. By positioning themselves on the frontier of this change in
thinking, investors can improve their decisions about what asset mix to hold
and what securities to invest in. Because of the many uses to which knowledge
about liquidity and financial frictions can be put and because of the luminous
manner in which the author makes difficult ideas simple, the CFA Institute
Research Foundation is exceptionally pleased to present this book.
Laurence B. Siegel
Gary P. Brinson Director of Research
CFA Institute Research Foundation
September 2014
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