I would like to know if when there is a financial crisis (such as a
speculative bubble, or any other kind of market shock) there is
necessarily low liquidity. Or equivalently, have there been any cases
of a financial crisis with a highly liquid market?

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Clarification of Question by ludo_z-ga on 15 Sep 2005 07:53 PDT

I was wondering whether a financial crises is necessarily a time of
low liquidity. In a time when everyone rushes to sell (let's say any
asset of some sort which is associated to a secondary market) it could
probably be much more difficult to find someone to buy, and
consequently the asset should become illiquid. However I imagine that
usually the market clears, as some people may buy at very low prices,
thinking that such a low price will eventually turn into a profit
after prices rise again. In this case the market is still perfectly
liquid, as there are still some very bold people willing to buy.
    The reason why I am asking this is the following. I was wondering
if liquidity could be used as an indicator of how valid the efficient
market hypothesis is, in an analogous fashion as friction can be an
indicator of how much Galileo's laws of motion hold. In my view a time
of financial crises is a time in which all investors follow more their
social herd-like insticts and rely less on rational calculations and
therefore that in a financial crises the efficient market hypothesis
cannot hold.
    By the way it could be argued that following the masses can be
rational. I do not believe this, as my personal view of rationality
relies very much on the view of Kant in "What is Enlightenment"
(substituting Enlightenment with rationality):
 
Enlightenment is man's emergence from his self-incurred immaturity.
Immaturity is the inability to use one's own understanding without the
guidance of another.
This immaturity is self-incurred if its cause is not lack of
understanding, but lack of resolution and courage to use it without
the guidance of another. The motto of enlightenment is therefore:
Sapere aude! Have courage to use your own understanding!

    Therefore in my view a social type of behaviour (which arises for
example in financial crises) is very different from a rational type of
behaviour, where at least in theory, a single individual may evaluate
on his own what he thinks the correct price of an asset is, and
therefore decide completely on its own if he should buy or sell
without looking at what other people do (if not to check his
calculations).
 
    Summarizing, I was wondering if liquidity can be seen as a measure
of the efficient market hypothesis. Since I think that in a financial
crises the efficient market hypothesis cannot hold I can restate the
original question asking if a financial crises always leads to
illiquidity.

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Clarification of Question by ludo_z-ga on 18 Sep 2005 05:26 PDT

I suppose that a depression should always be a time of low liquidity
since economic stagnation would lead to few people trading, and few
willing (or with the means to buy).
It is possible that a stock market crash, or any toher financial
crises may lead to a depression, as the 1929 crash or the japanese
bubble did. There could therefore be a cause-effect relation between a
financial crisis and a depression.

In my question I am refering only to the first stage. That is the
moments in which the stock market is plunging, and not the subsequent
situation.

Ludo_z -- 

Wouldn't a hyper-inflation, such as occurred in the Weimar Republic in
the early 1920s or Brazil during the 1990s, suffice to create the
economic depression?
http://www.nationmaster.com/encyclopedia/Hyperinflation

At the point of hyper-inflation, all savings & investment activity is
hindered and depression follows rapidly.

Best regards,

Omnivorous-GA

omnivorous-ga, I think you misunderstood my question. Depression
occurs very often after a financial crisis, and there are many
examples of this. My question was about liqudity (see
http://en.wikipedia.org/wiki/Liquidity). "The essential characteristic
of a liquid market is that there are ready and willing buyers and
sellers at all times".

There are some formal (mathematical) models of the economy which try
to explain what happens in the real world. They make some simplifying
hypothesis, and the more these hypothesis are close to reality, the
better the model works. I think that an important hypothesis for many
models is to be able to sell and buy quickly and without trouble,
which is the concept of liquidity.

If you want a historical example of a liquidity crises, consider what
happened in the last part of the 19th century in the USA. At that time
the country moveed to the golden standard. However gold was too
scarse, so there weren't physically enough coins for people to buy
goods with. This, in turn, caused depression.

This is an example of how illiquidity can lead to depression. My
question goes in the other direction though (and refers to a financial
crises), does a financial crises lead to illiqudity?

Ludo,
I will risk suggesting that by definition, as long as there is
liquidity, i.e., as long as people still have free funds (or credit)
and are willing to invest, there is NO financial crisis, even if the
market falls rather fast, as in the "crash of 1987."

http://djindexes.com/mdsidx/index.cfm?event=showavgDecades&decade=1980

Admittedly, that event was intensified by computer programs that sent
out "sell" signals.  If you will, the computers were all herding, and
the thinking people were just glued to the monitors with a misfounded
faith in ET analysis that had not yet been tested by the "exception". 
(That happened in other areas of financial dealing in the late 80s.)
A speculative bubble is a crisis in the making, people putting too
much money into speculation, borrowing to do so  - especially when
they are buying "on margin", using their high-flying assets as
security.  When the bubble starts to burst, they want to sell  - they
have to sell, because their creditors insist that they can only borrow
a certain percentage of the value of their security, which is rapidly
declining in value.  The situation snowballs, and many get caught with
unsecured debt, and lenders with unsecured loans  - i.e., no
liquidity.  The speculative value of the assets has disappeared, but
the debt remains.

This was not so much the case in 1987.  Maybe the market was
overheated, but there was adequate liquidity and hence no financial
crisis that led to a depression.

Here are a couple of sites about margin statistics and the mechanisms involved:

http://bigpicture.typepad.com/comments/2003/09/nasd_firm_margi.html

http://www.nasd.com/web/idcplg?IdcService=SS_GET_PAGE&nodeId=486&PrinterFriendly=1

Click on the blue texts for information.

I hope this is of interest, if not an answer to your question.
Myoarin