Lots of Liquidity Isn't Always Better

When you ask someone in the financial industry how his job creates value, he’ll often answer that it enhances liquidity. Why are high-frequency trading and other forms of algorithmic trading good for markets? Liquidity, we’re told. What’s the potential harm from the Volcker Rule, which prohibits banks from engaging in proprietary trading? It could decrease liquidity. There are endless academic finance papers discussing policies to improve liquidity.

But one question that’s rarely asked is whether liquidity is good. To many, this seems obvious. Liquidity is a notoriously hard concept to define, but broadly speaking, it means the ability to find someone to take the other side of your trade -- without it, markets break down. A liquidity crunch in the banking industry is commonly blamed for touching off the financial crisis and the Great Recession. Obviously, more liquidity is good, right?