The Global Money Machine

Robert Graves defined hell as "words repeated endlessly until they all but lose their meaning." "Liquidity" is one such word from the financial lexicon. Yet, properly defined, it is the clue to the potentially disastrous outlook for the global economy and financial markets.

It is a no-brainer to say that the credit crunch is making liquidity scarce. It is less clear why central banks are powerless to do anything to stop it contracting, and why this shrinkage will sabotage economic growth as economies fall prey to the credit drought in places as far-flung as the Baltic states to China, as well in the OECD countries.

But to back up for a minute, what is liquidity? Two years ago, when confronted with financial-sector balance sheets and asset prices that were growing at a multiple of GDP and money supply that wasn't, we at Independent Strategy found our answer. At the time, there was precious little correlation between money and financial-asset prices. That seemed strange. Unless return on assets, measured by corporate return on capital, was rising exponentially, there was no justification for asset prices to be doing so.

Further research indicated that what was driving asset prices was the supply of copious and cheap credit with which to buy them. This type of asset money or credit was not counted in the traditional definition of liquidity, which is simply broad money, made up of central-bank money and bank lending.

The reason for the exponential growth in credit, but not in broad money, was simply that banks didn't keep their loans on their books any more – and only loans on bank balance sheets get counted as money. Now, as soon as banks made a loan, they "securitized" it and moved it off their balance sheet.

There were two ways of doing this. One was to sell the securitized loan as a bond. The other was "synthetic" securitization: for example, using derivatives to get rid of the default risk (with credit default swaps) and lock in the interest rate due on the loan (with interest-rate swaps). Both forms of securitization meant that the lending bank was free to make new loans without using up any of its lending capacity once its existing loans had been "securitized."

So, to redefine liquidity under what I call New Monetarism, one must add, to the traditional definition of broad money, all the credit being created and moved off banks' balance sheets and onto the balance sheets of nonbank financial intermediaries. This new form of liquidity changed the very nature of the credit beast. What now determined credit growth was risk appetite: the readiness of companies and individuals to run their businesses with higher levels of debt.

No longer could central banks determine how much debt was created. They used to do that by limiting the amount of central-bank money they supplied, which formed the base of all loans, and then obliging commercial banks to make reserves for every loan. This made lending capacity finite. Now that the loans didn't stay on banks' balance sheets, this control mechanism was ineffective. Lending capacity became almost infinite – for a while. Indeed, central banks didn't even control the price of money very well any more; again; risk appetite set how risk was priced and central-bank rates held very little sway over the outcome. Yield curves, which were inverting at the time, had the effect that when central banks raised rates, long-term credit markets reduced them.

The credit tide is now ebbing. Since August, the credit system has been frozen solid. Debt issuance for all sectors of the economy has plummeted. Banks don't trust each other's balance sheets (and they alone know how bad their assets are). The rates at which they lend to each other show the same levels of risk premium as at the outbreak of the crisis, despite central banks' efforts to inject liquidity into markets.

For these reasons the Federal Reserve this week announced joint actions with central banks around the world to ease liquidity conditions. The Fed said it will initiate a series of auctions under the Term Auction Facility (TAF) that will inject funds to a broader range of participant depositary institutions against a broader range of collateral. The minimum rate of interest charged will be the expected fed-funds rate over the term of the loan. The auctions start on Dec. 17 for an amount of $20 billion to be lent for 20 days. Other auctions are planned for Dec. 20, Jan. 14 and Jan. 28. At the same time, the Fed set up bilateral swap agreements with the Swiss National Bank and the European Central Bank, so that these central banks could also borrow U.S. currency to fund dollar liquidity needs among their own banks.

These measures are an extension of what central banks were doing anyway: substituting central-bank money for funds normally lent and borrowed between banks in the interbank market. The funds themselves are not a "net" addition to liquidity, because they are paid back when the loan becomes due. The Fed's additional TAF auctions will help fulfill the responsibility of the central bank to ensure the proper functioning of financial markets by providing temporary liquidity. But they are not an additional easing of monetary policy or a bailout of banks' bad assets.

Therein lies the problem: The auctions address a liquidity shortage – caused by the banks' refusal to lend and borrow from each other due to mistrust of each other's balance sheets – but cannot address the solvency problem inherent in the balance sheets themselves.

Moreover, much of the leverage that fuels the economy is downstream from the banks, and on the balance sheets of nonbank financial intermediaries (such as brokers, hedge funds and investment banks) in the form of securitized debt and derivatives. Neither these entities nor many of the assets they own are eligible for central bank loans.

It was excessively optimistic risk appetite and consequent mispricing of risk that created this leverage problem. The reversal of risk appetite is now driving the deleveraging process. Just as the central banks were powerless to control the expansion of liquidity in the expansionary phase, it is unlikely that they can control its contraction and its economic consequences.

The deleveraging process will be ugly. First, the junk assets that the banks moved off balance sheet will have to be financed by the banks, and a lot of them will have to be moved back onto banks' balance sheets. As this happens, bank lending capacity gets used up. Second, re-intermediated junk assets will have to be written down. This destroys bank capital and further reduces lending capacity.

Finally, future bank lending practice is going to be changed. Much more lending will be kept on banks' balance sheets. When loans are securitized, banks will remain responsible for the quality of the credit and have to make prudent reserves against it. All this means lower liquidity expansion, particularly of asset money, and lower economic growth.

In a globalized system, no one is immune. The big shock of 2008 will be that the China bubble pops. After all, where would China be without excessive global liquidity flooding into its domestic markets over a quasi-fixed exchange rate and excessive household borrowing stoking U.S. consumer demand for China's goods? We are about to find out.