Destroying the myth of liquidity crisis

Of course I am aware that a guy from Eastern Europe will not rid the world of this lie. But it is worth  a try.

All we heard about since August was about the perils of the liquidity crisis. People all over the world debated the issue and the roles of the central bank in solving it. Liquidity crisis was the main reason advocates of the lender of last resort for central banks irrespective of if the borrower was solvent or not put forward. As we saw yesterday they have won this argument for now.

However, what the hell is a liquidity crisis? I am here to tell you that today it is just a big scam. Of course it could happen and it did happen but not right now. The world is not lacking cash. Central banks are trying to hide the fact that the global system is riskier and just plain sick.

Central banks manage liquidity in the money market daily. Each central bank has a different short term objective which is connected to their medium to long term one: stable prices. In very simple terms the role of liquidity management from the central bank is to keep the money market rates around the key policy rate. They monitor the money markets, where the demand and supply of short term liquid assets meet and thus are either injecting or taking out liquidity in order to keep interest rates stable and at the level they want. Now imagine that done every day in every country in all the currencies and also cross border. It sounds very complicated, it is not, but mistakes will happen. Sometimes, because of wrong bets, sometimes because of systems, the reasons can be multiple.

Nevertheless, central banks all over the world do a pretty good job in keeping the money markets fairly calm most of the time.

Then how does a so called liquidity crisis sneaks up on them? Or better yet how do we spot a liquidity crisis? Most of the people, including traders in the money market, will say that the signs of liquidity crisis are found in higher interest rates. Or better yet in higher spreads.  For example they are saying that the difference between a 1 month interest rate and a 6 months one is getting higher because the latter one is increasing. Other example could be that the interest rate at which some countries are borrowing is getting higher relative to benchmark (which between us is chosen arbitrarily). Another one is a general increase in the LIBOR rates, another benchmark. I hope you get the idea: liquidity crisis means higher borrowing costs for banks, governments and in the end for you and me.

But this is not the interpretation I see for a liquidity crisis. Liquidity can only be in “crisis” if it is drained somewhere from the monetary system. As I said, the only ones able to drain liquidity out of the system are central banks. Otherwise the amount of money in the system remains the same just that it is transferred from one owner to the next. Thus to me, I would look for signs of liquidity crisis in the money supply developments.

Here are two examples, US and EU (money stock).


Does it look to you like there was a liquidity withdrawal from the monetary systems? No to me.

Here is an example of how would a liquidity withdrawal will look. This is a graph of M1 (money stock) in Romania and I hope you can all spot the drop in liquidity (stock) in October 2008.

But we do not see anything like this in US or Europe. We know, however, that interest rates have increased in the money markets and bond markets. If it is not due to liquidity withdrawal why have interest rates increased? Why are indebted countries forced to borrow at higher an higher rates? Why are banks seeing the cost of short term liquidity increasing? The amount of money has not changed.  Yes, but the risk perception has.

Now we get to the real issue. The world is not dealing with a liquidity crisis. The world is dealing with a phenomenon called cash hoarding due to the increased risk of countries not paying back their debt or banks failing. The market participants are judging Greece, Italy, Portugal etc. as countries that will have a problem paying back their debts. They are looking at banks and see that they have still losses in their books to deal with in the future.

In this environment, the reaction from the market participants is  normal one.  It is not a market failure and it is not a liquidity crisis. All we see is a normal increase for those times in risk premium. The world is a riskier place and investors demand to be rewarded for that.

What the 5 central banks did yesterday was just to inject a bit of “morphine” into the global monetary system to numb the senses of the savvy investors. Going forward they can keep doing it or allow markets to do their job.

If they keep doing this, we will have the same effect as morphine has for a person with broken bones. It might induce them get up and try walking. Do you think they will be able to?

18 thoughts on “Destroying the myth of liquidity crisis

  1. I think they are afraid that if they operate that person (with the broken bones), the person might not be able to walk again. So they concluded that the best thing for this patient is to keep him calm for as long as they can. Therefore I see only two options: either the doctors are replaced somehow with others more confident (though this is hard to accomplish) or the patient becomes tired of the treatment and demands a more radical solution to his problem.

    1. This is the current target for central banks in almost all countries: low and stable inflation. Now, we can debate if that is the optimal target for a central bank or even if we need a central bank. But that is for another post. But by all means let me know if you think central banks should have a different target.

      1. Thanks, I read some of those. But is more fun to write my own views.🙂
        Funny how this post was about “liquidity crisis” but we talk about central banks and inflation

      2. “But by all means let me know if you think central banks should have a different target.”

        No, central banks shouldn’t exist at all. Different currencies should be backed by something real. And any bank, institution or company should be able to issue their own bank-notes.

    2. From wikipedia (about inflation): “Today, most mainstream economists favor a low, steady rate of inflation. Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduce the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.”

  2. First of all, what the central banks did yesterday is not such a big deal. I mean this can’t fix the sovereign debt problems. It is a solution for liquidity crisis, but those liquidity crises are a consequence of solvency issues. So this measure is not addressing to the causes of crisis. However, stock markets surged and yields on european debt fell below critical levels. The magnitude of this rally is impressive and scares me. It seems that the market can stay irrational as long as you have one more bailout. How many are left?🙂

  3. I’m not even an economist, but you are taking M1 as an argument ? What about M3 that depends on the money velocity and fractional reserve banking ? When the loaning slows down, the M3 tends to shrunk, no ?

    1. @MihaiVoicu
      Mihai, when we speak about liquidity in the money market M1 is the best estimate or any narrow form of money supply. M3 is good to look at developments in the credit market.

  4. Mihai Voicu,

    I hope you agree that when you want to gauge the “liquidity”, the most appropriate way is to look at the money stock (i. e. M1). So, from this point of view, there is no liquidity crisis as you can see on the above charts. What Florin wants to point out is the lack of confidence in the financial markets that brings higher costs for barrowers. Therefore, this risky environment requires more resources to shift money towards M2 and M3. Finally, you should look at M2 and M3 as an effect not as a cause of this financial crisis.

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