Dollars and Jens
Thursday, March 29, 2012
liquidity bubbles
The simple reason is that as individuals pass into middle age they attempt to increase their savings. One way to do this by loaning or renting resources to the next generation. However, as the population ages opportunities to do this are more and more rare.

This implies that savings can only take place through capital deepening. In essence this means more investment per worker. This expansion in investment per worker causes some types of capital to liquefy. That is, existing pieces of capital can readily find a buyer at fundamental values.

Yet, once capital liquifies it begins to earn a liquidity premium – like the one earned by US government debt now. This, in turn, drives the market price on the capital even higher and we enter a bubble.

In practice, the capital object itself doesn’t get moved around but a financial instrument entitling someone to the rents from the use of the capital or a debt secured by the capital. However, the effect is the same. The financial instrument becomes liquid, starts to earn a liquidity premium and then goes into a bubble.
I'm not sure whether I agree with this, but it's interesting. John Cochrane made an aside along these lines in his 2011 American Finance Association Presidential Address.

To really understand asset pricing, I think I'd need a substantially better understanding of liquidity than I have.

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