Liquidity
Credit Bubble Bulletin, by Doug Noland
Easy Liquidity
October 29, 2004
prudentbear.com
My quest for a better grasp of money, Credit and contemporary finance will always amount to a work-in-progress. Admittedly, there will forever be holes in our understanding, but the gaps are what keep us digging and contemplating. There are, as well, the critical and especially challenging issues of financial innovation and “evolution.” Things, they are always changing. So it is an exciting area to study, appreciating that there is so much to learn and always and everywhere new twists and turns to wrestle with.
I recall back to the early nineties when I just couldn’t accept the traditional and hardened consensus view that only banks create Credit. As an old CPA, I would draw out T-accounts on my note pad and do battle with scores of debits and Credits. It took awhile, but after tireless rehash it did sink in that what we were really dealing with at a fundamental level are electronic debits and Credits in a massive financial system general ledger. The banking system definitely does not hold a monopoly position within the financial sector when it comes to issuing electronic IOUs. Yet I had little success in recreating my epiphany for others. Frustratingly, analytical hostility seemed to flow more freely.
I was eventually able to break through on the non-bank Credit creation issue, but it was more a “Fine, non-banks might be able to create Credit, but they certainly can’t create money!” So the nature of the debate evolved. I tried to frame the “discussion” on the reality that myriad financial institutions within the Credit system create debits and Credits (issuing IOUs), while defining contemporary “money” in the context of “special” IOU’s (Credit instruments) that were perceived to be safe (stores of nominal value) and highly liquid. Contemporary “money” is generally more of an intellectual concept within an analytical framework than it is a practical tool.
I have always emphasized that contemporary “money” is a subcategory of total Credit. “Money” is Credit, but Credit is not necessarily “money” – most of it is not. As it has been throughout history, money must be shepherded and safeguard as its special attributes nurture over-issuance. It is worth noting that contemporary “money” is, as well, highly “intermediated,” meaning that its perceived safety and liquidity is dependent upon risk intermediation by various banking institutions, governments, the GSEs, Wall Street, ABS/MBS trusts, derivatives, Credit insurers, and others. There is little doubt in my mind that the huge mushrooming of contemporary “money” poses a potentially devastating systemic risk in the event of a breakdown in the perception of “money’s” safety and liquidity.
In the spirit of the great Mises (and traditional Austrian monetary analysis), my focus is always on a broader definition of financial claims (“fiduciary media”) that operate with a similar economic functionality to traditional narrow money. Today, this would include a broad array of Credit instruments including deposits from banks, savings and loans, as well as depository accounts in other institutions such as money market funds, insurance companies, and security brokers. “Repo” assets also fit within the definition, as do short-term liquid instruments issued by the Treasury, the GSEs, ABS/MBS trusts and highly rates finance companies. But this evening I don’t want to get bogged down in formulating a list of contemporary “money” or attempting its quantification.
I will, though, briefly discuss its expansion, and I will begin by recalling the traditional bank “money multiplier” example. A bank can increase its deposits (money) by simply debiting/increasing its asset Loans, while crediting/increasing it liability Deposits. This is money creation out of thin air, but it is actually an exercise of little practical significance. Not until the depositor takes this newly created deposit and does something with it (creating purchasing power) does this money expansion have a real effect. It may be spent on consumption or investment, or placed on deposit elsewhere or invested in marketable instruments. And remembering back to the “money multiplier” exercise, the multiplying of money occurs when this deposit finds its way to another bank. There it provides immediately available funds that can then be lent (additional debt and Credit entries) – thus creating new deposits that can be lent again, funding additional deposits (“immediately available funds”) elsewhere. Today, with effectively no reserve requirements, bank deposit IOU’s can be lent, deposited, re-lent and deposited with little if any constraint (“infinite multiplier effect”).
I will address two issues: First, money creation is of less overriding analytical concern in this process compared to when this bank IOU (deposit liability) is “on the move” generating purchasing power – creating Liquidity. The nature and effect of the Liquidity creation and increased purchasing power (inflationary manifestations) is of much greater analytical significance than the quantity of monetary inflation. Second, the IOU in this example can these days find its way directly to myriad financial institutions/”intermediaries”/instruments where it provides immediately available funds that are then lent or invested (additional journal entries expanding IOUs and Liquidity in the process). This bank IOU could “flow” directly to a money market fund, providing funds to finance Fannie’s portfolio expansion, purchases by an ABS trust, or to fund security speculation through a “repo” (repurchase agreement) transaction. Or the deposit could bypass the managed funds altogether and go directly to institutions such as the GSEs, the REITs, GE Capital, or even Countrywide (creating, perhaps, commercial paper IOUs).
Importantly, various financial sector assets and liabilities are created by debiting and crediting accounts throughout the clearing process. Some of these IOUs would be captured in the monetary aggregates, while others would not. Nonetheless, the issuance of financial claims that creates purchasing power augments system Liquidity. And it is not that there is any “money” physically moving through the financial system, but only an ongoing re-accounting and inflation of (electronic journal entry) financial claims. To stubbornly focus narrowly on some perceived special role and mystical power of bank deposits is to miss the very essence of contemporary finance.
It is also worth pondering the radical transformation of contemporary payment systems. In the past, the payment clearing mechanism was basically monopolized by commercial banks, with various transaction balances cleared through the transfer (through journal entries) of deposit asset and liabilities between banks (with bank reserve accounts at the Federal Reserve playing an instrumental role). In such a payments arrangement, one could somewhat accurately refer to the “velocity” of (narrow bank reserves) money as it “circulated” through the banking system and supported Credit expansion (and GDP).
Today, however, the notion of velocity is an anachronism that only impinges upon clear analysis. Rather than narrow bank lending and deposit “money” operating at the core of system (debit and Credit entry) payment clearing, I would strongly argue that various marketable securities and instruments have become the centerpiece for settling transactions involving myriad financial intermediaries (banks, GSEs, global central banks, Wall Street firms, finance companies, ABS/MBS, mortgage lenders, insurers and government entities). Simplistically, the payment clearing system today is dominated by ongoing trading of marketable assets and liabilities between various financial operators (at home and abroad). I would also posit that during this Credit Bubble blow-off period, systemic Liquidity has become precariously divorced from lending to the real economy. Financial sector leveraging and securities lending operations – the Masters of Speculative Finance - have become the epicenter of system Liquidity creation and destruction.
My focus this evening on money, Liquidity, and the contemporary payments mechanism is not an intellectual exercise. Indeed, flawed analyses of these critical issues were responsible for some of the past two years’ greatest analytical blunders. Many bright minds were convinced they saw global deflation, only to be blindsided by a spectacular surge in commodity and real estate prices. During last year’s fourth quarter, some trumpeted a decline in the monetary aggregates as an indication of faltering Liquidity and Credit contraction. Yet the reality was the opposite – continued massive Credit growth and over-liquefied global markets. To be sure, we don’t want to be absolutely wrong about Liquidity. Our analysis must downplay “money” and instead focus diligently on a very complex Liquidity.
The year ago decline in the monetary aggregates can be largely explained by disintermediation out of money market funds and a flight to higher-yielding securities and instruments (a “re-accounting” of investor assets and borrower liabilities from short-term “money” to longer-term “non-money”). Importantly, this contraction of M3 was actually indicative of a surge in marketplace Liquidity. To today categorically associate bank deposits and the monetary aggregates with general market Liquidity conditions is to leave oneself at a significant analytical disadvantage. “Money” is not Liquidity. Liquidity is a “flow” generally created by the expansion of financial sector (including global central bank) liabilities that are used in the process of expanding asset holdings.
So what about today’s Liquidity environment and near-term prospects? Well, the analysis is especially challenging these days and definitely nowhere as clear as it was one year ago. First of all, my best gauge of systemic Liquidity conditions is derived from informed guesses as to financial sector (including global central bank and “leveraged speculating community” U.S. holdings) ballooning. And while I can these days produce a list of factors that will work to perturb financial sector expansion – weak dollar, faltering mortgage lending profits, disappearing speculative profits, thin lending margins and Credit spreads, regulatory issues, rising short-term rates and heightened risk aversion - we must be mindful that market dynamics today have the most profound impact on system Liquidity since at least the late 1920s. And, let’s face it, market dynamics often prove counterintuitive.
Case in point: While it was reasonable to forecast a major decline in mortgage Credit growth after the collapse of 2003’s historic refi boom, the correct analysis was that contracting total mortgage originations would only inspire the bloated mortgage finance super-sector to more aggressively hawk adjustable-rate, interest-only, home equity, 40-year, no down-payment teaser-rate, and subprime lending. Total mortgage Credit expansion did not slow at all from record levels. Rather, market dynamics dictated that an ultra-powerful industry and manic (asset-Bubble-induced) borrowers – together comprising an Acute Inflationary Bias – would sustain “blow-off” lending excesses and facilitate virtually unlimited Liquidity to sustain the Great Credit Bubble. Throughout the lending markets, contracting lending margins can, for awhile, foster a push for volume. Similarly, shrinking spreads can promote more aggressive leveraging – and resulting heightened over-Liquidity – for an overly-competitive and incredibly over-financed leveraged speculating community.
And when it comes to market dynamics, financial innovation and counter-intuitive developments, nowhere are these factors more in play than in the interest-rate markets. One could have expected that a Fed tightening-cycle combined with $425 gold and $55 crude to have had bond managers in a tizzy. Nope, not with the burgeoning TIPs market. Hedge fund managers and REITs worried about how to leverage MBS going forward? No worries; simply entice the homeowner into ARMs and create floating-rate securitizations for the leveraged players. At the same time, the explosion of variable-rate mortgages and floating rate debt does provide the fodder to satisfy demand emanating from the proliferation of higher-yielding short-term “money” funds. And with performance suffering, many bond mangers have unwound interest-rate hedges and, in the process, supported bond prices and systemic Liquidity. Too many positioned for higher rates ensures, in this over-liquefied world in which we operate, virtually assures rates move sharply lower.
And one can be pardoned for presuming that a $600 billion current account deficit would pressure the U.S. bond markets and exert a constraining influence on system Liquidity. It may have been, as well, reasonable to forecast that a rising rate environment would immediately impinge the Credit creating process. But yeoman’s work by global central bankers, mortgage lenders, and Wall Street investment bankers has to this point assured more than ample Liquidity. Financial innovation has become – along with his sibling Inflation – Liquidity’s best friend.
There is a long history of markets misreading and/or extrapolating unsustainable Liquidity conditions. This can be especially the case at key inflection points and/or manic marketplace dislocations. Blow-off excesses permeated the bond market during 1993’s second half, merrily disregarding fundamental developments that were setting the stage for 1994’s bond market rout. Abundant Liquidity and spectacular market gains throughout SE Asia were followed shortly by near financial Armageddon. And I will certainly never forget how U.S. bank and financial stocks surged to record highs in July 1998, only to be crushed over the subsequent three months as the U.S. financial system dodged its own financial catastrophe. And then there was the early-2000 historic “blow-off” and Liquidity melee throughout Internet, telecom and technology stocks that were quickly followed by collapse.
Often, faltering fundamentals actually play a role in fostering “blow-off” Liquidity excess. A massive short squeeze definitely was a significant factor in the final manic NASDAQ dislocation, with short covering and a panic unwind of hedges creating a burst of destabilizing marketplace Liquidity. Derivatives also can significantly impact Liquidity. Speculative derivative leveraging through options and other instruments back in 1993 were an instrumental factor in the final destabilizing bond melt-up, as they were throughout SE Asia a few years later. Those that wrote options and/or were on the wrong side of a surging bond market in the summer of 1993 were forced to take leveraged positions to offset escalating risk. It is today certainly worth recalling how a dangerous marketplace dislocation actually exacerbated Liquidity excess.
The end result of the 1993 “blow-off” was rampant Liquidity creation and attendant speculative excess that spilt over to Mexico and other markets. But fundamentals eventually won out. An abrupt reversal caught the markets off-guard, requiring an immediate liquidation of leveraged long positions. Meanwhile, the newly inflated ranks of the unhedged were caught heavily exposed from the dreaded abrupt “V” reversal in bond yields. The market’s “V” caused particular havoc for the dynamically-trading derivative players and leveraged MBS speculators. It is also this evening worth recalling how little time passed between over-liquefied market conditions and a near liquidity crisis.
But unlike 1994, the Fed has these days convinced the marketplace that it will move at a very measured pace, with absolutely no intention of doing anything that would disrupt the markets. In short, the Fed has promised Ongoing Easy Liquidity and the markets are positioned for as much. And, yes, making such assurances incites leveraging and financial sector expansion – exacerbating Liquidity Excess. Yet there is no escaping the reality that Ongoing Easy Liquidity poses the greatest risk to financial stability and the soundness of our currency.
To wrap this up, I’ll return briefly to theory. System Liquidity is today predominantly created through the process of financial leveraging. Speculative financial market returns are the driving force for monetary expansion, as opposed to financing investment in pursuit of true economic returns in the real economy. The great risk in this mechanism is that gross (“blow-off”) market excess can completely corrupt the market pricing mechanism with little hope for adjustment or self-regulation. Left to its own devices, such a maligned and dysfunctional system will self-destruct. The Fed has abandoned its responsibility for regulating an increasingly unwieldy Credit system, seemingly leaving the burden to our foreign Creditors. All the while, economic distortions and imbalances run deeper, financial fragility more acute, and unmanageable foreign liabilities more unmanageable. And as magical as today’s Ongoing Easy Liquidity appears to most market professionals, there is no avoiding the reality that it must end – one way or the other – to forestall a dollar collapse. |
