Wednesday, May 20, 2009

LIBOR's Drop

There are some who believe the decline in the LIBOR is solely the function of increased liquidity. One of the most important lessons of the credit crisis is that liquidity can be fleeting and that its existence cannot by itself alter the price of financial assets. The keepers of liquidity can withhold the money and do so in a moment's time, or they can release it just the same.

With respect to LIBOR, the fact that there is today more money than yesterday cannot alone explain LIBOR's drop. For example, excess reserves ramped up way back in October, and bank holdings of cash did, too, yet LIBOR was stubbornly high.

Whenever there is a surfeit of something, its price falls, but a surfeit of money alone cannot cause its price to decline. This was proven in the fall and winter months when the cost of money on many fronts remained high. Only since the start of the "green shoots" phase has the surfeit been subject to the laws of supply and demand and lowered the cost of money, because the suppliers of inter-bank funds have released their surfeit.

LIBOR's collapse has been a long time in coming, in part on the idea that the surfeit (excess reserves) would lower its price, but critical to the idea was that the surfeit would alter attitudes about risk-taking. There is hence a bit of a chicken-and-egg situation here, although in the final analysis no amount of "liquidity" is sufficient to keep the cost of money low in a frightful environment.

In the 1930s, Frank Knight said that uncertainty is a risk that can't be measured. This is known as the Knightian Uncertainty principle. In such a case, the keepers of money will demand a high price when there are uncertainties. In other words, LIBOR could not have fallen recently without the removal or reduction of uncertainties.

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