Liquidity Crisis

Liquidity is an illusory concept. You see, during boom all markets look liquid. But it quickly changes during the bust. As the saying goes, liquidity is a coward as it disappears at the first sign of trouble.

The shortage of liquidity is called a liquidity crisis. It occurs when the companies or financial institutions do not have the liquid assets necessary to meet their short-term obligations. In other words, they lack immediately available funds to meet financial commitments and other urgent spending. The 2008-09 recession showed very powerfully the detrimental consequences of liquidity shortage.

Liquidity Crisis and Gold

The link between the liquidity crisis and gold is not a simple one. The impact can be different in the short- and long-term. Liquidity crisis is a very special kind of an economic crisis, a very dangerous one, as it can induce or exacerbate deep recessions, such as Great Depression or Great Recession in 1930 or 2008, respectively. Hence, it can be very positive for the gold in the long run.

However, in the short run, investors desperately need liquidity, and are ready to liquidita whatever catches a bid. So they would rather not buy gold or anything else. On the contrary, they will sell anything they can to obtain cash. Gold is the ultimate emperor, but during crises, cash is king.

Indeed, the bankruptcy of the Lehman Brothers is the best example. Overall, the global financial crisis was positive for the gold prices in the long-run. However, the behavior of the price of the yellow metal was actually quite complicated around the ‘Lehman moment’. As one can see in the chart below, gold rallied in the second half of 2007, as the global economy started to reveal signs of an impending turmoil.

Chart 1: Gold prices (London P.M. Fix, in $) around the Lehman Brothers’ bankruptcy (from September 2007 to September 2009)

Liquidity crisis and gold chart

After the Lehman Brothers’s collapse, the price of gold initially increased, as fear dominated the financial markets. However, investors quickly started to need liquidity. And desperately. So they sold their assets, including gold, to obtain necessary greenbacks. The implication is that when gold serves as a source of liquidity, its price might actually fall at the beginning of the liquidity crisis as a result of fire sales.