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Thank you to the Institute of International Bankers for inviting me to speak about liquidity in U. Certainly, trading activity in recent days has brought additional attention to the subject of market liquidity. It is not my purpose, however, to opine on these very recent market moves--a comprehensive understanding of which may depend on consequent market developments and the fullness of time.

I would only note that while premiums on riskier assets rose some last week, markets are functioning well amid higher volatility, market discipline appears effective as investors are reviewing their positions, and overall liquidity does not appear to be in short supply. The balance of my remarks will focus on financial market liquidity from a somewhat broader and longer-term perspective. In recent quarters, we witnessed very strong credit markets, bulging pipelines for leveraged loan and high-yield bond issuance, and near-record low credit spreads.

Structured fixed-income products proliferated, and the investor universe expanded to match new supply. Global investment flows were proven noteworthy for the lack of home-country bias. Managers of private pools of capital--in all of its forms, private equity firms, alternative asset management companies, hedge funds, and investment banks--increased funding from many sources and through many structures. Due in no small measure to strong credit markets, leveraged transactions increased and the market for corporate control became increasingly robust.

Fund managers of private pools of capital seized upon this opportunity to acquire more-permanent sources of capital: Is liquidity at strong and sustainable levels, justified by economic fundamentals?

What is likely to be the liquidity trend going forward? I will then discuss the primary sources of liquidity in the U. I will conclude by discussing implications for the economy and policymakers. The traditional concept of liquidity relates to trading: This definition is sufficiently general to encompass many ideas. Indeed, when different measures of the money supply were established, it was with an eye toward determining the liquidity of the underlying assets; as an example, components of M1 were considered more liquid than those in M2.

It is in this sense that some observers view the stock of money as a measure of liquidity, and changes in these measures as roughly equivalent to changes in liquidity. I doubt, however, that traditional monetary aggregates can adequately capture the form and structure of liquidity many observe in the financial markets today.

Instead, market observers are more likely to be referring to liquidity in broader terms, incorporating notions of credit availability, fund flows, asset prices, and leverage. Liquidity is optimally achieved when myriad buyers and sellers are ready and willing to trade. The trading is enhanced by market-makers and speculators alike. Underlying this concept is that while buyers and sellers have different views on the most likely outcomes--that is, after all what generates trading--they largely can agree on the distributions of possible outcomes for which they demand risk-based compensation.

Consider liquidity, then, in terms of investor confidence. Liquidity exists when investors are confident in their ability to transact and where risks are quantifiable. Moreover, liquidity exists when investors are creditworthy. When considered in terms of confidence, liquidity conditions can be assessed through the risk premiums on financial assets and the magnitude of capital flows.

In general, high liquidity is generally accompanied by low risk premiums. This view highlights both the risks and rewards of liquidity.

The benefits of greater liquidity are substantial, through higher asset prices and more efficient transfer of funds from savers to borrowers.

Historical episodes indicate, however, that markets can become far less liquid due to increases in investor risk aversion and uncertainty. While policymakers and market participants know with certainty that these episodes will occur, they must be humble in their ability to predict the timing, scope, and duration of these periods of financial distress.

Recall the market turmoil related to events in Asian financial markets in and following the Russian bond default in the summer of That is, powerful liquidity in the U. When fund flows are strong and growing, there is little reason to expect trading positions to become inalienable.

My goal in proffering this proposition is to improve the discourse by reducing the different notions of liquidity to its most fundamental feature. This exercise may also serve as a healthy reminder: If unmoored from fundamentals, confidence can give way to complacency, complacency can undermine market discipline and liquidity can falter unexpectedly.

If, to the contrary, confidence is justified by real economic determinants, liquidity can flourish. Of course, some might disagree with this definition of liquidity. They may argue that any excess liquidity in financial markets results from too little capital investment, here and abroad, which may arise from a lack of confidence in future economic outcomes. For example, high cash balances at U. Previously, however, I argued that while the build-up of cash since has been unusual, the most pressing determinant was not uncertainty about the profit potential of capital investment.

By my proposed definition, we must ask what forces have increased liquidity read: I will turn, first, to two key drivers of liquidity: A third important source of liquidity--resulting from the excess savings of emerging-market economies and those with large commodity reserves--has also found its way to the United States in pursuit of high risk-adjusted returns.

We must judge the extent to which each of these three liquidity drivers are structural or cyclical, more persistent or more temporary. Understanding the sources of liquidity--and the causes thereof--should help inform judgments about the level and direction of market liquidity.

In so doing, we may better understand its implications for the economy and policymakers alike. First, liquidity is significantly higher than it would otherwise be due to the proliferation of financial products and innovation by financial providers.

This extraordinary growth itself is made possible by remarkable improvements in risk-management techniques. Hewing to my proposed definition, we could equally state that financial innovation has been made possible by high levels of confidence in the strength and integrity of our financial infrastructure, markets, and laws. Moreover, remarkable competition among commercial banks, securities firms, and other credit intermediaries have helped expand access to--and lower the all-in-cost of--credit.

Interest rate risk and credit risk exposures are now more diversified. Look no further than dramatic growth of the derivatives markets. In just the past four years, notional amounts outstanding of interest rate swaps and options tripled, and outstanding credit default swaps surged more than ten-fold. These products allow investors to hedge and unwind positions easily without having to transact in cash markets, expanding the participant pool.

Syndication and securitization also lead to greater risk distribution. CLOs allow loans to be financed primarily with high-rated debt securities issued to institutions like mutual funds, pension funds, and insurance companies.

For CLO structures to be effective, they invariably must include a more risky equity tranche. Even the most sophisticated financial products are not immune to the physical Law of Conservation of Matter--the risk must rest somewhere. Hedge funds reportedly have served as willing buyers of these riskier positions, and we are all aware of their phenomenal growth.

As important as the participation of hedge funds, the derivative products themselves allow credit risk to be hedged, which has the beneficial effect of further increasing the pool of other investors as well.

The increase in financial product and provider innovation appears to be quite persistent; future trends, however, are likely to be significantly influenced by legal, regulatory, and other public policies. The second factor, perhaps equally persistent, supporting strong investor confidence in U. In theory, reduced volatility, if perceived to be persistent, can support higher asset valuations--and lower risk premiums--as investors require less compensation for risks about expected growth and inflation.

In this manner, confidence appears to beget confidence, with recent history giving some measure of plausibility to the notion that very bad macroeconomic outcomes can be avoided. The Great Moderation, however, is neither a law of physics nor a guarantee of future outcomes. It is only a description--an ex post explanation of a period of relative prosperity. If policymakers and market participants presume it to be an entitlement, it will almost surely lose favor.

Let us look closer at the correlation between confidence and outcomes. Asset prices do appear somewhat correlated with volatility associated with the real economy and inflation. For example, equity valuations for U. In addition, term premiums on long-term U. Treasury securities are estimated to have declined substantially since the late s. These flows to the United States from global investors lead to higher liquidity by increasing capital available for investment and facilitating greater transfer and insurability of risk.

Also, some of the fastest growing economies, especially in Asia, pursued export-driven growth strategies, thereby accumulating large reserves of foreign-denominated assets.

In a world of funds increasingly without borders, we would expect investors to seek out the best risk-adjusted returns. Sound, transparent regulatory and legal frameworks in the United States, United Kingdom, and some other advanced economies have helped contribute to the attractiveness of these markets.

In addition, top-notch infrastructure allows for efficient clearance and settlement procedures for transactions in the most sophisticated financial markets, all of which promote investor confidence and continued sources of liquidity. Implications for the Economy and Challenges for Policymakers Generally, high levels of liquidity offer substantial benefits to our financial system and overall economy through higher financial asset prices and a more efficient means to channel funds between savers and borrowers.

Strong liquidity may also help to prevent imbalances in certain markets from spreading because of the greater dispersion of risks. Financial markets have been buffeted by a number of significant events, including a spate of corporate accounting scandals, the bond rating downgrades of Ford Motor Co. But the effects on broader markets appear to have been remarkably contained. It is harder still to know precisely why.

I have argued that solid fundamentals--effective and dynamic products and markets to disperse risk, stable economic performance, and robust and attractive market infrastructures--are key underpinnings for strong liquidity and correspondingly strong investor confidence.

Surely, policymakers must be vigilant to maintain output stability and low and anchored inflation expectations. In addition, policymakers need to encourage sound risk management by private participants as the first line of defense against financial instability. Of course, investor confidence and liquidity can shift. In the aftermath of a financial shock, if buyers and sellers of credit can no longer agree on the distribution of possible outcomes, their ability to price transactions will be severely limited.

While we cannot--and often should not--prevent all shocks or predict how they will reverberate through the financial system, we can attempt to create conditions that would lead investors to most quickly rebuild their confidence.

That is most likely to occur when underlying fundamentals are solid. Monetary policy is no less challenged by the level and prospects for liquidity. We policymakers must ask whether liquidity conditions are obscuring signals from financial asset prices that we would otherwise use to gauge the performance of the real economy.

Of course, inferences from market prices are always imprecise, because prices depend on expected growth, the variation surrounding that expected path, and investor risk aversion, none of which we can precisely observe. Market liquidity may further confound the inference challenges. Allow me to comment, nonetheless, on a few key indicators. Look at the current configuration of Treasury yields across the maturity spectrum.