May 28, 2006

Global liquidity feeds off climate of uncertainty

Posted in International Economy · 10 comments ·
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What goes up must come down, and go up again, and come back down. That has been the story of the financial markets over the past few weeks, suggesting that, in the spectrum of greed and fear which drives investors, most do not know which way the pendulum will swing next.

One thing is clear, however: there is a huge amount of liquidity sloshing around the world looking for a home, which makes the oscillations of the markets extremely volatile. Where is all this money coming from?

To answer this question, we must go back a few decades and get into the minds of today�s senior central bankers. Most of these men – you will see them nodding sagaciously to each other at high-powered conferences like the Davos forum – are products of the 1970s. Their formative years were spent learning the theories of Milton Friedman and other monetarists and, in the process, debunking those of John Maynard Keynes. Their overriding fear is inflation – the type of inflation the world experienced in the early 1970s and which persisted till the early 1980s. The Holy Grail for these central bankers is low and stable inflation. Provided that is achieved, everything else should look after itself.

By the mid-1980s, inflation had been beaten – mainly via the excessively blunt instrument of recession, and with it, high unemployment and the disappearance of large swathes of industry. The central bankers achieved this by increasing interest rates to such an extent that our economies ground to a halt. If people are out of work, they don�t spend, and if they don�t spend, prices don�t rise. Most countries have recovered from these man-made recessions and, arguably, most are in better shape now.

Typically, we would have seen yet another inflation cycle playing itself out by the late 1990s – except that the world was hit by the biggest economic shock in a century. The collapse of communism and the rise of globalisation opened up China, India and Russia to the game. This has had the effect of doubling the world�s workforce and, in the case of China, creating a new sweatshop producing cheap goodies for the rest of us. One of the main ramifications of this has been no inflation. As long as China produced stuff cheaply, the prices of consumer durables fell back, and we in the west got cheap goods. This suited the narrow-gauge central bankers down to the ground. They had their low inflation and now they could let things sort themselves out. If people wanted to borrow, well, let them borrow.

So we have seen an enormous expansion of credit around the world in the past few years. Equally, Alan Greenspan – formerly the capo di tutti capi of central bankers – reacted to the dot.com boom by initially believing the hype and, latterly, printing money to ensure that the dot.com bust didn�t knock the entire US economy out of kilter. So both the upswing and the downturn were characterised by large injections of money into the US system. If this cash was not going to technology businesses, where was it going? It found its way into every other nook and cranny of the system, from the housing market first, and later into commodities and back into old-fashioned stocks.

Global liquidity works a bit like a champagne pyramid. Imagine a tacky wedding with a pyramid of champagne glasses and a gushing bride who begins to pour from the top. Eventually, the champagne finds its way into even the most remote glasses as it overflows down the pyramid. As each layer of glasses fills up, the next layer begins to do likewise. Now think of global financial markets. If the central bankers at the top open the taps, global liquidity flows initially into the top triple A assets, such as prime property, bank stocks and strong companies and into well-run economies.

Then this market overflows, so the excess cash finds its way into other more risky assets. As these fill up with cash and yields fall, the speculative cash goes further afield looking for return. Eventually, as long as the taps remain turned on, even the riskiest projects, regions and ventures get cash.

As a result of the champagne pyramid, liquidity seeps everywhere. So we are left with a situation where everything from speculative mining stocks in Canada, to apartments in Bulgaria and defaulted Iraqi debts get snapped up. In other markets, the sheer weight of liquidity drives prices up to levels never before seen. We are experiencing this all across the commodity markets, the housing markets and in some areas of the stock markets.

All these cycles are the same. Initially, there is the real fall in the level of interest rates and cash starts to flow. Typically, the first investment logic is flawless and is underpinned by sound economics. Take the recent example of most metal prices. The price of copper had been low for long periods.

Then in comes China with strong demand for the metal and investors put two and two together. The Chinese will buy more copper, so let�s buy in tandem, piggybacking on a fundamental change in the global financial/economic backdrop.

So far, so sensible. Then greed takes over. As the price of copper rises, people think that it can only go higher, so more money pushes the price up further. We begin to get into a cycle where the very fact that the price is going up is sufficient to validate buying further.

The ��if you�re not in, you can�t win�� syndrome takes hold. Greed drives the prices up and then suddenly, at a certain lofty point, investors are gripped with a fear of heights. It is as if they get the wobbles when they look down. Overnight, the greed that got them into the market, making them dizzy with optimistic excitement, turns to total fear and they freak. Panic selling begins and prices collapse.

We have seen this type of bipolar behaviour in almost every market in the past week or so. In many ways, the world�s central bankers have created a monster. Instead of inflation, we are getting asset price bubbles in every market from exotic property, to copper and steel, classic cars and Irish art – all driven by the fact that there is simply too much liquidity around.

But now we have a dilemma. The central bankers realise that the impact of pricking the bubble now on jobs, incomes and politics could be so debilitating that, every time there is a scare in the markets, they react by cutting interest rates and injecting more cash. This simply re-rates upwards all prices and we are back into the same cycle of greed and fear – but at higher starting prices. The champagne glasses start to fill up one more time.

So the world�s central bankers are caught in a new type of liquidity trap. As long as traditional inflation does not rise too much, they can�t puncture the asset price bubble, and are condemned to inflate it. But if inflation were to pick up, the bankers could aggressively raise interest rates with a clear conscience, which would be akin to hurling a bowling ball at the champagne pyramid. Party over!

These are the stakes in the global financial markets. The central bankers find themselves in an intellectual cul de sac; investors are trapped by the flawed logic of the last throw of the dice and, all the while, the markets yo-yo up and down. In the absence of a logical and painless exit strategy from this volatility, the only thing people can think of doing now is fastening their safety belts and bracing themselves.


  1. John

    We still live by the same economic laws we always did these
    are based on human ‘needs’ and ‘wants’.
    In most of the credit driven western world
    the ‘wants’controlled mostly by desires are the driving
    forces in our economies.
    The need for shelter has been turned into a ‘want’,the want
    for a bigger house the want for a house in a better area
    the want for equity and the want for early retirment
    provided by an overvalued house.Is it only a matter of time
    before the price of other necessities like food and
    clothing are cleverly manipulated by the marketing people
    to way beyond there true values?
    Only when people become more rational and suppres their
    desires for ‘things’ and status can economic stability be
    maintained,as this will not happen today or tomorrow then
    maybe controls on marketing techniques need to be applied
    by governments. Compulsory seatbelts and crash helmets for
    our desires?

  2. Jim

    There is a logical, though not painless, solution: drop
    paper, start using gold as money.

  3. Malcontent

    This article was very funny. I loved the fact that the
    author pretended that the economy had rules or cause and
    effect as if it was pysics or something.

    There is no cause and effect in economics. No economist can
    make a testable hypthesis, test it, and then have the
    results repeated by somebody else. It’s likey psychiatry
    except that it’s less predictable.

    Very funny article. I laughed out loud.

  4. arthur

    malcontent – you are wrong -just because the cause and
    “precise” effect are hard to analyse,test and repeat does
    not mean they do not exist! It will always be harder than
    physics because physics has one set of immutable rules
    whereas people (with the possible exception of yourself) are
    adaptive creatures and learn new stuff all the time and
    their behaviour changes making any social science extremely
    difficult to analyse. Now go back to your lab or cave, pls,
    and stop sneering and living out your eponym.

  5. dude

    There is no bubble. Real inflation is off the charts,
    believing government statistics on inflation is about as
    wise as believing in the justifications for the Iraq war.

  6. Brain

    Some say capitalism is the only way others say it leads to
    disaster.Marxist communism was the antidote for seventy
    years.It was a disaster.
    Global capitalism is here now and called globalisation, we
    have all been sucked into a roller coaster of speculative
    economics and when the superrich,who control everything
    anyway, get scared for one reason or another we will see
    another Wall Street crash but bigger.Remember it took ten
    years of socialist(government funded) economics in the U.S.
    followed by a World War to recover from the 1929 crash.

  7. Pete

    The article suggests that the central bankers are itching
    to increase interest rates, as soon as rising inflation
    gives them the green light to do so. But remember, they
    control how inflation is measured, and they have choosen
    to watch house prices and commodity prices and energy
    prices soar and still smugly produce reports showing low
    inflation. That suggests to me that they are doing
    everything they can to avoid raising interest rates, and
    will probably continue to do so until eventually the bond
    markets do it for them.

  8. John Doe

    What I find surprising presently. Is the relatively low
    yields on long dated Euro Bonds and American Treasury
    Bonds. I agree with posters that the official CPI figures
    published in Europe and the US seem a little ‘optimistic’;
    inflationary pressures caused by rising Oil and commodity
    prices are building.

    I appreciate that much dollar debt, for instance, is
    bought by shady hedge funds (the Fed?) and by the
    Japanese, Chinese and Saudis, but might they stop buying?
    If they did stop buying dollar debt in such vast
    quantities would bond rates in the US not go ballistic?;
    causing mayhem amongst debt junkies?.

    If I was American, I would find it unnerving to know that
    my country’s economic future ( in part) lay in the hands
    of a communist and an Islamic dictatorship.

  9. ian

    message to martha,
    martha this is a serious website and blog for people who
    are interested in the future of ireland. if that is the
    best you write, will then i suggest you stay with female
    ireland and continue to bake.

  10. John Doe

    Martha,
    I’ll refrain from making any half baked comments, however
    I’m glad that you’re using your loaf, it’s obvious
    somethings cooking(in the world markets)..etc.
    (said in a Dr Evil voice)

    John Doe

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