Thursday, 13 March 2014

Global liquidity: have we created a monster?

Money in the financial system overwhelms all it encounters making it a growing threat that needs to be dealt with

We are being overrun – by money.  There may be worse things to have battering down one's door but a surplus of cash in the financial system can have scary consequences.  The financial system was set up to facilitate the movement of cash to parts of the economy where it is needed but has instead become a behemoth exerting a dominating influence over the creation of goods and services in the actual economy.

Quantitative easing feeds the beast by flooding the banking system with even more cash in the hope that a few crumbs will drop down into the actual economy.  However, not only is the financing no longer having the desired effect, but the extra money is becoming increasingly erratic and hard to control.  Policies are needed to yank banking back into line.

Money getting out of hand

Spare cash in the form of savings is the basis for economic growth.  Surplus from current production is invested to enable higher output later on.  Banks were first created to shift extra money elsewhere so that production could be expanded.  Yet, banks have gone beyond the basic operation of allocating money and moved into the business of making money from money.  This is a waste of resources considering our best and brightest could be put to better use.  But more than that, the colossal size of the financial sector is in itself a problem – it is like a giant trampling everything in its path.

Money is free to move around the globe on a whim.  Too much free-flowing cash turns into a menace in terms of stability.  The danger always seems close at hand – banks and others creating more cash out of thin air by increasing leverage when times are good while central banks unleash a mass of new money to shore up the economy when things turn bad.  Yet, money is not always forthcoming - the impact of the global financial crisis was exacerbated by a flood of cash fading to a trickle.

The money is out there lurking and waiting.  The skulking leviathan surfaces only in a few places but creates distortions wherever it emerges.  A clear example is the property prices in London and other places in the UK which are booming at a time when the underlying economy is stuck in a faltering recovery.  Emerging markets have also fallen victim to the ebb and flow of global finances due to their less developed financial markets and limited domestic savings.

Making money work for us

If massive money movements are causing chaos, it is only sensible to conclude that greater controls should be put in place to rein in the rampaging.  The current direction of policy on finance has turned to re-regulation after decades of deregulation gave banks the freedoms which allowed the phantom cash to wreak havoc.  The finance sector has railed against any restrictions, but the monster now rearing its ugly head cannot be left uncaged.

It is argued that free movement of money is essential despite the risks, as credit is cheaper as a result.  But even the cheap cash from central banks has not been enough to convince banks to lend which suggests that easy money does not bring the benefits previously thought.  This means that we should not fear the utilization of policies as controls over the movement of money, the separation of retail banks (which take in savings and give out loans) from investment banks (which deal in financial wizardry), or the introduction of higher standards for banks in each individual country.  Money in itself is not evil – it just needs to be kept in its proper place.


  1. Yes, well put.

    Could the problem be rooted in a fundamental change in the way bankers think about "investment." I mean, in the old days, bankers would think in terms of investing savings in the community and gaining a return. Today bankers seem to think like addicts and gamblers who want the highest, fastest gain, no matter what the risk (short term "investment" in risky emerging markets and others who have to pay high interest rates ---ie risky sovereigns who might never repay) to get return.

    But lets ask what would happen if U.S. interest rates rise?

    Its so basic and obvious, interest rates are a cost to all business and to the U.S. government for bond payments. what?

    Well the stock market would start going down to factor in this cost.
    Business might slow or stop hiring. other words, contraction.

    The main problem the Fed fears is how much of a contraction can the U.S. economy take before it turns into long term deflation.

    The problem is we have borrowed too much money for too long and now we have to pay it back, but nobody wants to suffer the years of austerity this would probably create...(look at the PIIGS countries)

    I think the Fed has only two choices today....deflation ( and for how long), or this crazy experiment into the unknown....easy money for as long as it takes, and that could be 20 years.....Leave it to the U.S. to try what others have never tried, in other words, to gamble with all of our futures no matter what the consequences. That's what the Fed is doing and its really stupid because the outcome is really unknown....This is the mentality we are living with...try something new and see what happens.

    So rational economics is not what is at play here, its a combination of theory and risk, which is the U.S. culture. Its like a compulsion to not do the known, but to risk trying the unknown. That's how I see it. And I don't like it, because I like more certainty. But when I look at contracting countries like Greece, I don't like that, and when I look at deflating countries----Like Japan---which is not improving and not paying off their massive debt....

    The question to be solved is how do we keep jobs and payback debt without crashing the economy? We could do that by rebuilding all our infrastructure as one example....but our political system is failing. So here we are, with a Fed that is the only functioning actor. Economics has answers, but people cant cooperate to save themselves.

    1. Thank you for this comment. You seem to be struggling with the same issues and concerns that I am working through in this blog.

      One thing that I would like to add is that I do not share your worries about uncertainty of monetary policy. We are dealing with a situation that has never been encountered before. Something similar has happened in Japan but policy makers there have not had any luck in solving their issues.

      The new circumstances will require new policies and I am more frustrated with a lack of willingness to try new things. Printing money is not a problem as long as it does not create inflation and central banks could be more inventive in terms of getting this money into the economy. New macroprudential measures which are started to be used in the UK are also a positive step to developing a range of tools for monetary policy. In particular, these measures may help delay the need for higher interest rates which may be a major damper on the economic recovery.

      I think that it is tough to argue for higher interest rates at the moment and central banks should be looking for ways of delaying for as long as possible. But considering that low interest rates have not been that helpful for the economy, higher interest rates may not make that much difference. We shall have to wait and see...

  2. Dear N.E.
    Like the blog
    I think too much debt is still the problem and the money printing hasn't been enough to overcome it + Harry Dent's points on demographics - the financial; effects of the baby boomers moving into retirement is huge
    This mathematician , Steve Keen, has done some great work on the problems of debt

    1. Hello Ben

      Thank you for your comments.

      I agree that the problem of debt is central to the current problems with the economy. The excess global capital is more like a symptom of a lack of investment opportunities in the actual economy but it does throw up issues of its own.

      Thanks also for the heads up on Steve Keen. I am actually already a fan and use a few of his ideas as inspiration for bits of my blog.