Liquidity andBubbles

[tnu]

I'm a little shaky on how these work and what they are I'm debating keynesian on hard currency versus fiat money wherein the keynesian argues that gold and silver have reduced liquidity because they are not a "legal tender" (which i'm assuming means they aren't backed by a state) and are subject to market bubbles. Anyoen care to educate me more on this?

[MrBogosity]

Bubbles are by definition a monetary phenomenon, so it's ludicrous to say you can have a gold or silver (or Bitcoin) bubble. What they do, especially as being the world's second most popular reserve currency in the case of gold, is respond to what's going on in the market--including financial bubbles. Their function is to have something that people can sell off to gain liquidity when the market tank, boosting the recovery.

Saying that they're "subject" to market bubbles is like saying your mechanic is "subject" to your car breaking down.

[BogosityForumUser]

Another two notes I think are important. 

First is what liquidity is.  There are two overlapping concepts, but liquidity is the ability of an asset to be exchanged for cash while simultaneously not affecting its market price.  The faster and easier it is to do that, while not affecting price, the more liquid it is.  For example, gold is extremely liquid because you can literally sell metric megatons of the stuff and the price (for everyone, including you) won't be affected by the single transaction and there is a supply demand balance that people will readily exchange for it.  However, walnuts are not very liquid.  If I show up somewhere with a metric ton of walnuts to sell, the supply and demand can get out of whack and the act of exchanging will have a great effect on the price.  Now note, just because a large number of transactions will affect the prices, that does not mean that it is not liquid.  Instead, you need to look at individual transactions.

Second is what legal tender is.  Legal tender are those mediums of exchange that a government grants the legal tender rule to (which is completely different from the perfect tender rule).  The legal tender rule is that the very act of offering it (tendering) changes the legal relationship between the parties.  The most important change is that interest can no longer be charged on the debt. 

For example, Alice and Bob make a contract where Alice gives Bob a car in exchange for a $5000 CHECK in six months, plus 1% interest for every month it is late.  Now, if on month six, he offers her $5000 CASH and she rejects it, what happens?  Even if he never gets her a check and she ends up suing him years later, the most she can get on the debt (not including cost associated with going to court) is $5000, not a single dollar of interest.  That is because of the legal tender rule and the fact that he offered the cash.

To quick notes about legal tender, it does not have to due with the backing of the state and it is distinct from the perfect tender rule.  The backing of the state means that when it comes due, the state is guaranteeing that they will pay for it.  This does have a huge effect on liquidity, but not because of legal tender status.  For example, treasury bonds are highly liquid because people know they can get the value of the bond when it matures, but they are not legal tender.

The perfect tender rule means that if you make a contract, you can (in most cases) reject any item of value that is not a perfect match to what you agree to.  So in the above example, the perfect tender rule allows Alice to reject the cash because they agreed to a check; however, the legal tender rule means that she doesn't get interest.  Furthermore, if Bob had instead offered her some treasury bonds worth $5000 (which have the backing of the state but are not legal tender), then Alice can reject them (under the perfect tender rule) and is still entitled to the interest (because it is not legal tender).