Editor's Note: The following is in answer to a reader's question "What do they mean when they talk about global liquidity drying up?"

In remembrance of my high school biology teacher, who always reminded us that the only stupid question is an unasked question, I offer the following explanation.

Financial analysts and news reporters often refer to the concept of "liquidity," as though it were a magic wand. One touch and all ills are cured. Until recently, it was often heard that "the world is awash in liquidity," which was considered a good thing. More recently, the en vogue observation is that "global liquidity is drying up," which is spoken in ominous tones.

Liquidity and You
What is liquidity? Liquidity is simply a measure of how quickly an asset can be converted into cash. Ultimately, liquidity is cash, because cash can immediately be exchanged for just about anything else.

Financial assets such as stocks are liquid, but how liquid depends on the market and the stock. With a phone call to your broker, or even the click of a mouse, you can convert most of your stocks into cash - immediately. The market for most stocks is "liquid" because there are so many participants, and there is always a buyer - at some price.

Real estate - for example your house - is less liquid. Unlike with stocks, you cannot click a button and convert your house into a pile of cash. Would that it were so simple. Selling a house is a long, arduous process. You may have to do some prep work first - painting, repairs, maybe some upgrades, then you have to find an agent and show it around. Strangers come traipsing through your living room on Sunday afternoons, peeking in your closets. In a highly liquid (hot) market, you may only have to suffer such indignity for a few days, and receive a price much higher than you expected. In an illiquid (slow) market, you may have to suffer months (or even years) of this treatment, and still not get an acceptable price.

In Detroit, some houses are selling for less than the price of a new car. This is an example of a very illiquid market - lots of people want out of the city. There are few jobs and less hope. They want to sell, but few people want to buy.

Then we come to the once haughty (soon to be lowly) hedge fund. Having money in such a fund can be even less liquid than a house in Detroit. Some hedge funds have suspended redemptions which is akin to saying, "Yes, your money is here and it is (ahem) safe -but you can't have it just now..." When can you have it? Well, that depends. Maybe never, as investors in two Bear Stearns hedge funds found out a few weeks ago. Earlier in the year their investments were doing just fine. A few months later, nothing was left.

What Causes Liquidity to "Dry Up?"
Liquidity - the ability to turn an asset into cash - requires other people who are willing to pay cash for your asset. Modern bank accounts rarely suffer from liquidity crises. In the past, such liquidity crises were known as "bank runs." Mobs of people would rush to the bank to withdraw their funds, but the bank didn't have the money. This is a classic liquidity crisis - the bank most likely had the assets (mortgages, loans outstanding, hedge fund investments, etc.), but the assets couldn't be converted to cash quickly enough (i.e. immediately) to satisfy the rioting mob. Bank runs have been rare since the Great Depression because accounts are now insured by the government.

A mini stock market panic - like the one we saw last week - is a form of liquidity crisis. As long as stock prices are rising, people want to buy more and more shares. They will even borrow money to buy shares, and banks will readily lend them the money. There is no fear that the money will not be repaid, because the collateral against the loans (stocks) are going up.

But like last week, when stocks suddenly fall, buyers disappear. Stockholders, like homeowners in Detroit, and their hedge-fund-holding brethren, want to sell, sell sell! They want to be "liquid," but buyers are only willing to buy at lower prices - much lower. "Ridiculous!" the would-be sellers might say. It is much better to wait, and sell in the inevitable rally that will follow. (Maybe the rally will even be so good that they won't have to sell at all!)

But not so fast. The banks that loaned them the money to buy the stock in the first place have other ideas - namely getting their money back, with interest thank you very much. They demand repayment in the form of the dreaded margin call. This forces shareholders to cough up more money, or "liquidate," i.e. convert assets to cash even if they don't want to - even if they're going to lose money. The bank will not lose money.

The factors discussed above are, cumulatively, the factors that determine global liquidity. The font of global liquidity springs from the world's central banks, which create liquidity by "printing it" as Fed Chairman Bernanke famously revealed. In truth, Central Banks do not print money, they loan it, and loans need to be repaid.

The Fed sets interest rates (the discount rate and the Fed Funds rate) at which banks can borrow money. The interest rate on money is just another way of setting the price of money. When the interest rate is low, money is cheaper. Like cheap anything, there is more demand for cheap money, and there is also correspondingly more supply. Since it is so cheap, more of it has to be lent in order for banks to make a profit.

The recent housing boom in the United States was the result of cheap money. Since interest rates were at historical lows, people borrowed more. Banks, corporations, individuals and the government borrowed lots of money because it was so cheap. They all thought they could use the cheap money to their advantage. The government borrowed a lot of money and had a war. Corporations borrowed a lot of money and bought their own shares. Individuals borrowed money and bought houses. Banks had access to so much money that they let their lending standards go - nearly anyone could borrow money to buy a house, start a hedge fund, whatever! This is what is meant by global liquidity. There was so much money sloshing around the globe, just looking for a home.

As noted however, borrowed money eventually has to be repaid. Because so much money was lent, and lending standards were so lax, it turned out that a lot of people couldn't repay their loans. A bank's response when a person can't make their monthly payments is often to demand full repayment. Borrowers who couldn't come up with monthly payments certainly couldn't come up with the full balance, so they defaulted. Hedge funds that invested in mortgages and derivatives also lost money - lots of it. The banks that loaned the hedge fund money issued margin calls - the same way they issue margin calls to individual investors.

Suddenly, with the thought of money actually being lost (or more accurately, as I noted before - destroyed), banks have become less willing to lend, because investors are less willing to buy the banks debts. Investors - having already been burned - are rather looking to sell what they own. Since everyone is thinking the same thing, there are few buyers. No one wants to spend his cash, borrowed or not. Ergo, liquidity - the ability to convert assets to cash - "dries up."

The result of a lack of liquidity is nearly always the same: falling prices. Just as rising prices can create a virtuous cycle of ever-higher prices, falling prices can create a destructive cycle of lower prices as credit is destroyed and asset prices collapse. The housing market in Detroit is one example.

Only when this destructive cycle is complete - after prices have fallen as far as they are going to - are assets once again viewed as bargains. At that point, demand again rises and liquidity lubricates the flow of rising prices.

A word to the young, mobile and wise would-be homeowners - check out Detroit.