What can we learn from country-level liquidity in the EMU?

The recent experience during the debt and banking crises in the European Monetary Union (EMU) has demonstrated how important it is to consider liquidity (or rather the lack thereof) in macroeconomics. Similar to the Fed's policy during the US real estate crisis, the ECB took huge efforts to insert liquidity into the banking sector to prevent further financial turmoil, only to find that the transmission mechanism was severely hampered. Strong heterogeneity during the crises accentuated the difficulties of a common monetary policy. The main contribution of this paper is to show that properly measured liquidity contains substantial information on macroeconomic dynamics. Liquidity overcomes two problems of using interest rates (and interest rate spreads) as the main indicator of the monetary and financial side of the economy. First, contrary to the policy rate, they include information on the different impacts of monetary shocks between countries, thereby accounting for heterogeneity in the transmission mechanism and the different states of the banking sector. Second, (growth rates of) liquidity indicators are not subject to the zero lower bound problem and are thus particularly useful when considering samples, such as the recent crisis. We propose a range of liquidity indicators, based on Theil-Tornqvist index number, that are designed to account for measurement problems during times of financial turmoil, when liquidity preference - and thus the price of liquidity - can change quickly. We then study the information content of those variables. (C) 2019 Elsevier B.V. All rights reserved.