The 21st century liquidity trap: Our only way out is for policy-makers to end their austerity policies and restart QE policies

 
Michael Howell
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Is this what plunging bank share prices and rising financial stress gauges are telling us? (Source: Getty)

The 2008 crisis started with a solvency problem that led on to a liquidity problem, which resulted in an economic slump.

Today, we start from a liquidity problem that is causing an economic problem, which may ultimately lead on to a solvency problem. Global liquidity is becoming ‘trapped’, an idea first popularised by John Maynard Keynes

The ‘liquidity trap’ describes a situation where central banks become impotent and monetary policy no longer works in stimulating economies. Technically, it represents unlimited hoarding of ‘safe’ assets by the private sector. This extreme risk aversion prevents the re-cycling of funds and so freezes liquidity.

This follows because fewer ‘safe’ assets in circulation deprive credit-providers of their lending base, since ‘safe’ assets are the collateral foundations on which new credit is built.

Put differently, wholesale markets, such as commercial paper and eurodollar deposits, and new credit providers, like shadow banks and money market funds, are eclipsing high street banks in importance. In the 1930s, cash was the main ‘safe’ asset, but today this definition must be extended to also include their use of high quality bonds.

In a modern liquidity trap, there are three reasons why these long-term liquid assets become frozen.

First, regulatory requirements, such as Basel III and Solvency 2, force insurance and pension funds to side-pocket bonds.

Second, a ‘hunt for yield’, when low or negative interest rates force investors to buy longer maturity bonds that provide better returns.

Third, a ‘scramble for duration’, when the lack of quality long-term assets push pension funds to buy more government bonds.

This lack of ‘safe’ assets traps liquidity and compromises future credit growth, which, in turn, leads on to weaker economies and slower inflation.

Dangerously this comes at a time when the wholesale markets are themselves being hit by the sharp slowdown in inflows of US and European corporate cash and deposits from commodity-producers.

It is important because tighter international credit makes it harder for cash-strapped Chinese and emerging market firms to borrow. The resulting slowdown in the domestic Chinese economy is encouraging investors to pull-out money. Latest data show China haemorrhaging capital at a $100bn monthly clip. China’s large global footprint means this credit slowdown must feed-back negatively into world markets.

Our only way out is for policy-makers to end their austerity policies and restart QE policies sufficient to boost spending and the supply of good quality collateral.

The alternative negative interest rate policies adopted by much of Europe and now Japan, threatens monetary oblivion by taxing liquidity, destroying collateral, forcing down the yield curve and crushing bank lending margins.

Is this what plunging bank share prices and rising financial stress gauges are telling us?

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