Bubble Trouble

The liquidity drunks have taken over the economic asylum. 


Listener: 3 May, 2008 


Keywords: Macroeconomics & Money; 


The standard explanation of the ongoing world financial crisis is that the United States Government has been running a huge fiscal deficit, which has poured liquidity (cash and near-cash) into the world economy. This facilitated the creation of various complicated financial instruments (contracts that are assets to some and offsetting liabilities to others). When the financial institutions (banks) lost confidence in those instruments and were no longer willing to buy them from one another, the whole system imploded. 


Unfortunately, the high finance is linked to the most basic financial instrument – money as a means of payment. If that becomes useless, people cannot buy things, businesses cannot sell things and, if that continues for long, the economy loses production and jobs. Thus the high-flyers in the financial sector pose the Samson-like threat that they will pull the whole economic temple down on top of us unless they are bailed out. 


So the US Federal Reserve and other reserve banks of the world have been trying to avoid the breakdown by buying good-quality financial instruments that the banks have been unable to sell when they needed cash. 


US economist Joe Stiglitz says the new policy approach is the opposite of the prescription the US Treasury and the International Monetary Fund imposed during the financial crises of the 1990s. He suggests they have not learnt they were wrong then, and are simply favouring their financiers and countries. 


The US Fed would ask what is the alternative? To let the entire payments system seize up and crash the world into depression? 


It may be supporting the banks, but it is trying to penalise their shareholders, so they won’t do it again. (Yeah, right.) 


The bailing out involves increasing the amount of liquidity in the economy, but … er … isn’t that what got us into the mess? It seems a bit like having “a hair of the dog” the morning after. There is a minority who say there is nothing fundamentally wrong with the financial system that additional liquidity would not fix. They admit that sub-prime loans and the like are a problem, although these loans are being written off. But, they say, most of the new financial instruments are sound and are only temporarily affected, and the best treatment is for the reserve banks to buy them if they become illiquid. 


It sounds like a liquidity drunk who thinks another glassful will solve the problem. It may in the short term. But what are the medium-term consequences? 


You do not have to be a hard-line monetarist to fear that liquidity injections will lead to inflation. The Japanese experience is instructive. By the end of the 1980s, Japan’s financial system was riddled with poor-quality financial assets, which were kept on the books rather than being written off as valueless. The resulting slow adjustment meant near stagnation in the Japanese economy over the past 15 years. 


Today’s banks are making huge write-offs of their sub-prime investments. They say “this time it’s different”, although those four words are among the most dangerous in the bankers’ lexicon. It may well be that the current financial crisis will hang over the world economy for a long time, and that the international economy will suffer a long stagnation. 

Robert Wade, the New Zealand economist with a chair at the London School of Economics, who has just been awarded the prestigious Leontief Prize for Advancing the Frontiers of Economic Thought (Wassily Leontief was a Nobel laureate), argues the causes of the financial crisis lie even deeper in the architecture of the global financial system, which made possible the US deficits. If he is correct, the current remedies will be ineffective. 


The Bank for International Settlements said a year ago, before last August’s credit crunch, “years of loose monetary policy have fuelled a global credit bubble, leaving us vulnerable to another 1930s slump”. I’ll drink to that.