In the outstanding 1980s miniseries about the development of the first atomic bomb, Day One
, the Hungarian physicist Leo Szilard is quoted as saying that he always keeps his suitcases packed and at the door. Szilard had been a victim of European anti-Semitism.
In fact, the movie opens with a Jewish scientist catching the literal ‘last train out’ of Berlin, which creates the emotional backdrop for Szilard’s need for sudden mobility. In a growingly oppressive state, bags already packed vs. clothing in dresser drawers can make all the difference in the world. I wondered when I watched Day One how much of a price one had to pay in lost convenience day after day in order to gain the agility which may, or may not, be needed when the day suddenly comes to move.
That reminded me of something I’d read in Benjamin Anderson’s outstanding book about the economic history of the early 20th century, Economics and the Public Welfare. Anderson is a must read for anyone who wants to understand the economics and finance of that period, and anyone who, like me, is interested in learning the principles of classical finance, free from the distortions of Keynesianism and Modern Portfolio Theory. Anderson made the case that the more locally deployed capital was, the higher the return, and contrarily the more liquid it was, the lower the return. Mobility requires a sacrifice of return. Anderson says:
“Selling on the stock exchanges at the outbreak of the war was an illustration of a fundamental principle in economic life. When there is general confidence in the uninter-rupted goings on of economic life, confidence in the legal framework under which economic life operates and in the essential integrity and fairness of governments, men with capital prefer to have their capital employed. They want income from it. They want capital to work with, as giving additional scope to their personal efforts and their personal abilities. They are quite content to have their capital embodied in physical goods destined for future sale, in shares in industrial undertakings, in real estate which brings in rentals, or in loans to active men engaged in industry and commerce. But when grave uncertainties arise, and, above all, when unexpected war comes, men prefer gold to real estate. The man who has his wealth tied up in lands can make no shift. He must sit and take what comes. With the apprehension of war. however, the effort is made to convert illiquid wealth into liquid form as rapidly as possible, even though heavy sacrifices are involved.”
In other words, although Anderson saw, as Keynesians did not, that interest rates are a function of economic growth, he also saw, as some modern supply siders do not, that interest rates are not identical to economic growth. The difference is what I am calling the liquidity premium.
Just because the interest rate is determined largely by the growth rate of the economy, it does not necessarily follow that the interest rate should be the same as the growth rate of the economy. My good friend and sometime mentor, Brian Wesbury, argues that the natural rate of interest is the same as the nominal GDP growth rate. Remaining consistent with this principle, Brian argues that when the Fed Funds rate (the rate set by the Fed) is lower than the nominal growth rate, the Fed is inflationary, and when the Fed Funds rate is higher than the nominal rate, the Fed is deflationary.
Wesbury has used this as a forecasting tool to arguably inadequate effect. Such a model which ignores the liquidity premium, when compared to subsequent history, seems to have a bias towards overstating inflation. But why? What’s wrong with this approach?
Well, first of all, let’s note what’s right about that approach. It acknowledges the most important point: that Fed distortions are terribly damaging. It acknowledges another important point: that you and I as savers and consumers are better off negotiating for ourselves, without The Bernanke turning our relationship into a managed a trois. It asks the right questions, but it leaves one out:
In a world of high regulation, how much of a discount will I offer to a borrower in order to keep the right to walk away at a moment’s notice? The answer is that I will be willing to pay a high price in order to remain mobile. That effect I call a ‘liquidity premium’, though I’m tempted to call it a Szilard Premium, because it is the financial equivalent of having your suitcase always packed at the door. And, financially speaking, the need to be mobile and the premium one pays for it is getting bigger all the time. The higher the threat of regulation of confiscation, the more distorted the interest rate becomes. In this sense the liquidity premium, like the inflation premium, is another interest rate distorter, and therefore another masker of the truth.
Imagine that you have five million dollars to invest and you are considering two options: one is to build a light industrial facility in an inner ring suburb and the other is a set of bonds. If you build the warehouse, you are stuck with it. If you decide to sell, you may have to wait years and take a huge loss. If you are selling for a reason such as a municipal tax increase or a labor union certification, it will be even harder to sell. You are lashed to the mast, which means you are more at risk than you would be with a bond which you can sell pretty much at will.
That’s why, all things considered, illiquid investments have to offer higher yields than liquid ones. And this is even more true of short-term instruments such as the overnight Fed Funds rate than it is of a longer term bond rate, because as a general rule, the shorter the duration, the lower the risk.
This effect is bigger than just a corrective to a friend’s inflation forecasting model. It should serve as a warning to us about an economic drag on the entire economy. The liquidity premium is a dead weight loss to the economy in that it is a discouragement to investment.
Once one adds up inflation premiums and liquidity premiums and tax hike premiums, one finds that the price of safety is to invest at a loss. The allegedly ‘safe’ side of the yield curve is being transformed from an investment sector to the world’s largest system of safe deposit banks. Instead of being paid for saving; on net we pay the system to hold on to our savings for us.
Mr. Bowyer is the author of "The Free Market Capitalists Survival Guide," published by HarperCollins, and a columnist for Forbes.com.