RateWatch #333 – Liquidity
December 7, 2002 By Dick Lepre
The BLS Employment Situation Report showed 40,000 fewer jobs and an unemployment rate of 6%. This is not the sign of a booming economy and enables us to "slip past" a report that could have sent rates up big-time. Treasuries started out in positive territory on Friday but gave ground to apparent short covering.
The next question is "what the heck has the recent equities rally" (before this week) been all about.
Some words about the "Iraqi thing". The near-term effect of the impending release of the Iraqi report will be on the price of oil. If the report appears to be deceptive then the time line for getting Iraqi oil back into the world economy will be drawn out and the price of oil will rise. If it looks
like Iraq is trying to get back into the mainstream then the price of oil will drop.
High oil prices = inflation = higher rates.
I think that there is a growing economic crisis that has not at all been addressed in the media. The concern is liquidity. First, distinguish between insolvency and illiquidity. An individual, company or government is insolvent when its liabilities exceed its assets. It is illiquid without being insolvent when its current liabilities exceed its current assets. It may have the "wealth" but the wealth is not in the right place at the right time.
Illiquidity does not stop there. It can refer to the entire economy. There can be a lot of money, but it may not be in the hands of the people who need it. The unwillingness to lend money to keep the economy going is the sort of illiquidity of concern at present. This might better be described as "economic constipation" but that is not a term en vogue with economists. At present it does not seem that credit-worthy businesses are clamoring for money but cannot find it. It seems more as
if they are not interested in making investments. But it may become the case that just when they want to start borrowing banks will be unwilling to lend.
Two significant "events" triggered the 1998 event. The Asian Currency Crisis and the as yet unnamed crisis which we will call the LTCM Syndrome. The LTCM Syndrome here describes a set of bad decisions by very bright economists which resulted in losses by not only hedge funds such as LTCM (Long Term Capital Management) but also large commercial banks such as BofA.
The Fed saw an imminent liquidity problem. Think of the problem from the point of view of a banker. Asian economies which had been going great were suddenly in crisis. Hedge funds started by Nobel prize winners needed to be bailed out by the Fed. The American branch of the largest Japanese securities firm has just taken a $1 billion hit. Your own bank is taking a multi-hundred million dollar hit. The stock market is down over 15%. Corporate profits are suspect. Who are you going to lend your bank's money to?
Illiquidity occurs in situations where banks may have money to lend but do not want to risk lending it. The expression "liquidity trap" describes a situation in which investors and banks simply hoard
money for fear of losing it to bad loans. A liquidity trap occurs when demand falls short of productive capacity even though interest rates are low. The "trap" occurs when lowering interest rates won't increase demand. A liquidity trap is a serious crisis of confidence. Japan's economy has, in the past, been victim to a liquidity trap.
Imagine You're Rich
To understand the liquidity problem make believe for a moment that you have a lot of money, say,
$500 million. Let's face it, you are made. You don't have to worry about investments. Do you
really want to invest in the stock market and maybe have $550 million in another 12 months?
No! What you want is to not lose any of your $500 million. So you aren't likely to invest or
loan it in a time of uncertainty. So you hold your money. Interest rates are low and your not making much but that is cool with you. You still have your $500 million.
Now, I am Greenspan and you are the tightwad with the $500 mill that won't lend or invest it. I have one sneaky ploy. I say: "Look, Scrooge, I'm going to let interest rates fall and business will cook and you know what? (and I say this very quietly to you) I don't give a bleep about inflation." Ahh! Now I've got your attention. Because one enemy of anyone with $500 million is our old friend, the I-Monster - inflation. He can eat it while you try to hang onto it.
Understanding the plight of the rich (ha!) also helps in understanding why investors in bonds and mortgage backed securities act the way they do. Remember this: they are not trying to make money, they are trying not to lose the purchasing power of the money they already have.
There are some large-scale problems and potential problems with this policy:
1) is the Fed rewarding banks for their mistakes? Maybe. But this can get to be a complicated issue. Making everyone pay for their mistakes may sound like a high moral road but it is impractical. I might make the case that there would be fewer auto accidents if there were no auto insurance and fewer fires if there were no fire insurance. But, we understand the value of insurance and the assignment of responsibility.
2) With so many foreign governments involved can we distinguish between illiquidity, insolvency and irresponsibility? Probably not. The on-line article by Dean (see below) deals with this extensively.
3) What is the role of the IMF? The IMF is like an international Federal Reserve. The most important thing is that politicians and politics have as little as possible to do with this. They have little to contribute. The role of the IMF in present day economics is nascent.
The events at the IMF meeting in Seattle in 2000 showed a population confused about the role of the IMF and having no concept of liquidity.
An excellent article about liquidity from 1998 when there last was a liquidity problem:
EAST ASIA THROUGH A GLASS DARKLY: