Beware of a Flood of Funds

Surplus cash in the global financial system has a history of leaving havoc in its wake and quantitative easing may be making the situation worse.

There is a lot of cash sloshing around the international financial system at the moment.  Central banks are still buying heaps of bonds and there are few places in the actual economy where people are willing to invest money.  Not having cash around in the financial system can make life very difficult as shown by the credit crunch where lending by banks ground to a halt and the global economy came close to collapse.  But too much cash in the financial system can cause its own troubles.  Cheap credit is one of the causes of the global financial crisis.  More recently, emerging markets have been tested by the coming and going of a massive tide of global funds.  What can be done to ensure that more of the world is not drowned in an excess of cash?

It may seem strange but there is a lot of spare cash around at the moment but no one wants to use it.  Companies are hoarding money as business people are not confident in being able to make money through new investments, and consumers are paying off debt while being worried if their jobs are safe.  Adding to this, banks are reluctant to lend as new regulations are prompting banks to be more cautious about the amount of loans on their books. 

Central banks have tried to alleviate this problem by making it cheaper to borrow, firstly, through reducing interest rates to close to zero, and when this has not worked, printing more money with which to buy bonds.  The bond purchases also serve to further lower borrowing costs, but businesses and consumers currently seem averse to taking out fresh loans no matter how cheap it is to borrow.  Nevertheless, the bond buying continues with the Federal Reserve alone buying US$85 billion in bonds each month.  The extra cash is not going into the actual economy as there is no demand for it and it is free to be moved to anywhere in the world.

So this money is not like a still pool of cash where money can be drawn as necessary, but rather more like a tidal system where funds will flow in one direction for a certain period of time before switching to another direction depending on the alignment of economic factors.  Any free funds will always move in search of higher returns and the flows shift as economic circumstances change.  The transient nature of the funds creates economic problems due to the temporary effect of lowering interest rates and creating a surge in lending, only for the money to flow out again at the first signs of trouble.  These flows of cash now dominate the world economy like never before and can leave havoc in their wake (for more, see Where is all the money going?).  

This ebb and flow of funds is given as one of the reasons behind the global financial crisis.  The size of the pool of cash had swelled due to a glut of savings in Asia which were invested in the United States.  The resulting lower borrowing costs spurred on excessive lending which extended to sub-prime loans, eventually causing the near collapse of the financial system.  Almost the reverse has been the case in previous weeks.  Extra cash generated by the bond purchases by the Federal Reserves and other central banks had found refuge in emerging markets which had continued to grow in the aftermath of the global financial crisis.  But the tide turned with the paring back of quantitative easing in the United States, which is expected to result in higher returns from investments in the US markets. 

The worst of the effects have been experienced by India, Turkey, and Indonesia who had grown more reliant on the money coming in from overseas due to imbalances in their own economy.  But emerging markets have shored up their defences after having often been caught up in the wash of global finances.  Countries with developing economies often build up large foreign exchange reserves which are used to counteract the outflow of funds (which was ironically behind the glut in savings in Asia seen as responsible for the global financial crisis).  The use of controls which restrict the movement of funds have also become commonplace and are even somewhat sanctioned by the IMF (who are typically ideologically opposed to any limits on the free movement of resources).  Even the new range of banking regulations in the United States and elsewhere, such as rules on higher levels of capital buffers, can be seen as a buttress against the swirling forces of global finances.

However, the new measures being adopted in developed countries and in emerging markets have the goal of merely preventing the symptoms of the problems created by the surplus funds.  Furthermore, foreign exchange reserves and capital buffers come with their own costs – this money could be put to better use when the economy actually needs the extra funds.  Would it not be better to deal with the problem itself?  Central banks could come up with a way of soaking up the surplus money in the world’s financial system.  Considering the global scale of financing, this might require a new role for an international organisation such as the IMF.  It would also involve a rethink of quantitative easing and the tools available to central banks since the freshly printed cash from central banks has added another deluge of funds and has created problems of its own (see Perils of doing too much for more detail).  It would be a sad day for economists if the aggressive policies from central banks to revive the economy from the latest crisis sow the seeds of greater instability in the future.