On Liquidity and the Financial Crisis

Like many economists, I simply could not believe that the Fed would be unable to pump up liquidity enough to stave off a major recession like the one the US has been experiencing. Even after the Bear-Sterns forced sale to JP Morgan, I wrote to MA saying that I couldn't imagine the US would slip into a recession as serious as that experienced in the early 1980s (he had written to me, saying he was sure it would be worse). My message to him back then said,

My best guess is that the only way this will happen is if the monetary authorities REALLY foul up (or if there’s some other major political upheaval). I’d say there’s perhaps a 1/4 chance of 1980s type deep recession, but even that is unlikely.

I pretty obviously had something wrong. Either the Fed waited too long to increase liquidity, or they were simply unable to increase it enough fast enough, or both.

My reading of The Money Illusion by Scott Sumner suggests to me that he believes the Fed did too little too late, that it was their choice (albeit a mistaken one) to keep liquidity at a level far lower than he thinks they should have aimed for.

But I wonder if something else was going on. What if, as I have mentioned before (see here and here), much of the liquidity on the system came from the shadow banks, not from the Fed and standard monetary system? From some of the reports I have read, I gather that perhaps as much as 40% of the economy's total liquidity was provided via the shadow banking system. Shut that down very quickly  (or have it nearly collapse) and that leads to one heck of huge drain on the overall liquidity of the economy.

Suppose the Fed did not fully realize the extent of the liquidity being provided by the shadow banks during the 2002 - 2006 period. Suppose, then that (as a result) the Fed had little idea how much liquidity was being lost as the housing bubble burst.

If these suppositions are correct, then several interesting implications follow:

• The Fed has had much less control over the money supply during the past decade than it did back in the 50s, 60s, and 70s. Velocity is difficult to measure and determine, high-powered money means much less, etc. So much for the 1960s version of monetarism.
• If the Fed wishes to target inflation rates (or nominal GDP, following Scott Sumner), it must have a better understanding of and control of the shadow banking system.
• If there really was a near 40% collapse of liquidity a year ago, then fiscal stimuli won't be very effective. Only as liquidity is rebuilt within the monetary system will the economy begin to emerge from this recession.This rebuilding process cannot happen quickly, especially given the general lack of trust in shadow banks.
• By not understanding the size and nature of the shadow banking system, I (and the other inflation hawks) probably encouraged central banks to worry too much about the inflationary impact of pumping liquidity into the economy.

Having said all this, I am still concerned about inflation in the future, but now the source of my concern is a worry that the US will increasingly monetize its growing and massive debt.

Comments

[Brock]

OR liquidity isn't the solution.

[Brent Buckner]

You write:
If there really was a near 40% collapse of liquidity a year ago, then fiscal stimuli won't be very effective. Only as liquidity is rebuilt within the monetary system will the economy begin to emerge from this recession.

If the U.S. economy were so far below an appropriate level of liquidity then shouldn't fiscal stimulus be effective in that there would be lots of idle resources and little crowding out?

Here was my favourite blog post on the credit money system:
The Roving Cavaliers of Credit
http://www.nakedcapitalism.com/2009/02/steve-keen-roving-cavaliers-of-credit.html

[Brock]

The article linked above (by Steve Keen) is outstanding. I read it about 6 months ago and came to the rather unsettling conclusion that I completely blew 30k and 2 years of my life studying a discipline that is completely useless. I learned more about how the economy actually works in from freshman accounting classes than from graduate level macro classes.

This crises is about debt. The big banks in the US are insolvent. Further, the American (and Canadian, though to a less extent) "consumer", be it corporate or individual/family is insolvent. We are up to our ears in debt. There is no recovery until the debt is dramatically reduced. Right now it is being hidden with accounting windowdressing.

Here's a great outline:

http://globaleconomicanalysis.blogspot.com/2009/08/global-debt-bubble-causes-and-solutions.html

I don't care for Mish so much but the video by Steve Keen (who wrote the Cavaliers of Credit article linked above) is outstanding.

Or as NR wrote:

"This is a crisis of solvency, not just liquidity, but true deleveraging has not begun yet because the losses of financial institutions have been socialised and put on government balance sheets. This limits the ability of banks to lend, households to spend and companies to invest..."
http://www.ft.com/cms/s/0/90227fdc-900d-11de-bc59-00144feabdc0.html?nclick_check=1