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Understand the liquidity myth and discover how to prevent it!

Understand the liquidity myth and discover how to prevent it!

Taking care of the financial management of a large company is an arduous, but rewarding task. All the details require great attention, and costs should be calculated with precision.

Thus those who have a better knowledge of the market and how it works have an advantage. Having a deeper understanding of the liquidity myth, then, can be of great help in terms of decision making. Keep on reading to learn more about this subject!

What is the liquidity trap?

The British economist John Maynard Keynes, in his work of 1964, classified the economy as a continual process in which cash flows. Within this flow, the costs of one person represent the gains of another, and so on and so forth.

To him, an economic crisis is caused by a psychological factor that motivates consumers to save — by economizing or investing — more than they consume and spend, creating a new cycle. This new order is a vicious cycle, in which less and less money circulates until it leads to an economic collapse.

Keynes also believed that the relationship between the Marginal Efficiency of Capital (MEC) and investments is negative, since the rate of returns compared to costs should exceed the interest rate, which doesn’t happen when there is a recession, and this feeds this vicious cycle even more.

Taking this into consideration, the trap in very general terms is that when investments fall, profits rise and vice-versa.

Why is the liquidity trap a myth?

In an article published by Mises Brasil, the specialist Frank Shostak makes pertinent critiques of this British theoretician’s thinking and proposes another view of this so-called trap: “Contrary to popular opinion, a liquidity trap doesn’t arise due to a massive increase in the demand for money on the part of consumers, but rather as a result of weak monetary policy which inflicts severe damage on the economy’s real savings.”

Or in other words, this liquidity “trap” is a myth, because it has a real effect not only on the valuation of a business, but also on investments made as well as the rate of return.

How does this happen in practice?

The Japanese economy in the 1990s is frequently used as an example of the supposed liquidity trap. Economics PhD Richard C.B. Johnsson uses a graph to demonstrate in another article for Mises that this theory regarding Japan doesn’t hold water.

The same logic holds true for the administration of a business. João Carlos Hopp and Hélio de Paula Leite, both professors at FGV (Getúlio Vargas Foundation), in an academic work published in 1989, state that “even if we were to use the market value (and not cost value) as a basis for valuing assets, net worth wouldn’t be a valid approximation of the value of a company. A company’s value is based on its future earnings.”

A corporation should protect itself from these risks with assertive decisions, employing impeccable business management in which planning is aligned with growth objectives. It’s important to have assets that can quickly be converted into cash, but long term needs to be considered as well.