Liquidity as Social Expertise
This paper proposes a theory of liquidity dynamics. Illiquidity results from asymmetric information. Observing the historical track record teaches agents how to interpret public information and helps overcome information asymmetry. There can be an illiquidity trap: too much asymmetric information leads to the breakdown of trade, which interrupts learning and perpetuates illiquidity. Liquidity falls in response to unexpected events that lead agents to question their valuation models, especially in newer markets, may be slow to recover after a crisis and is higher in periods of stability.
An early version of parts of this paper circulated under the title Lemons, Market Shutdowns and Learning. I am grateful to Marios Angeletos, Manuel Amador, Ricardo Caballero, Bengt Holmström, Juan Pablo Nicolini, Peter Kondor, Fabrizio Perri, Victor Rios-Rull, Iván Werning and various seminar participants for helpful comments. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research.