marcd77 (94.43)

Liquidity Is Not the Issue

November 12, 2008 – Comments (2) | RELATED TICKERS: GLD , SLV , UUP

I often hear liquidity being discussed as the main culprit behind the economic conditions the United States and to a lesser extent, the World are currently facing. It is important to understand that liquidity in and of itself may have been the issue in creating the economic conditions we are currently facing but in no way does it offer a solution.

Since 1971 and the United States abandonment of the Bretton Woods Accord the Treasury has more or less been able to expand the money supply at will without any requirements to back those printed dollars with tangible assets. In a perfect world in which government officials spent wisely and considered the impact of their spending on future generations this may not prove much of a problem. However in the real world the propensity to spend is too great and the printing press has offered far too jubilant of a tonic to Washington as a tool to ease the economic pain of any downturn, malinvestment or recessionary period.

There are many factors that have contributed to the United States ability to spend beyond its means and to accumulate levels of debt that are simply beyond what many could have imagined. The Bretton Woods Accord set the U.S. dollar on its course as the World's reserve currency, redeemable in gold and even after the abandonment of Bretton Woods, the dollar has so far been able to sustain its position. After the severance of Bretton Woods by President Nixon the United States found another way to support to the dollar. Often this is referred to as the de-facto oil standard where negotiations between OPEC Nations and the United States led to both an increase in the price of oil and the understanding that the oil produced by OPEC nations would be sold primarily in US dollars. This created significant demand for US dollars worldwide as many nations are net oil importers and they would now have to swap their currencies for US dollars in order to purchase the oil their nations required. This dollar demand has supported the currencies value and allowed the United States to both print incredible amounts of liquidity and maintain loose fiscal policy at the same time.

Via money supply expansion and incredibly low interest rates a period of overspending, overconsumption and mal-investment ensued where returns were chased into bubble after bubble regardless of fundamentals or more importantly the lack thereof. It was this excess liquidty that allowed various investment categories to reach disproportionate heights, the most recent being the housing market. Exotic instruments tied to housing values chased higher yields as the Federal Reserve left interest rates as levels that discouraged savings for average and instutional investors alike. The levels of leverage and liability built into these derivatives instruments became more and more complex as the market grew larger and ultimately risks were assumed that under normal conditions would have been considered highly unwise.

Our government leaders now feel it is wise to correct this problem by throwing more money into the fire and watching it burn while at the same time easing monetary policy to levels that once again discourage savings and encourage consumption and the accumulation of debt on personal, commercial and federal levels. The issue here is that so far this liquidity has done little to correct the problem. That is because liquidity is not the issue!

The exotic instruments tied to mortgage or debt obligations, often called derivatives trade over the counter or OTC. Essentially they have no exchange or regulation. As the markets determined that housing was overvalued and prices of real estate were set to decline these derivatives products underlying assets were now being questioned. The oversupply of derivatives coupled with lax monetary and lending standards brought into question how many loans were provided to borrowers at excessive risk and more importantly real state values that simply were not indicative of underlying economic conditions or household income growth. A disproportionate amount of a homeowners income was required to provide for the debt service on their homes. As real estate continued to tumble in price the existing derivatives markets tied to these debt obligations dried up. Essentially they could not catch bids in the marketplace and therefore cannot be valued. This is the issue creating the current economic conditions in the marketplace. The Lehman Brothers failure caused a significant number of OTC derivatives notional value to become real as the contract was due and payable upon the failure of either of the contracts entities. Lehman did not have the ability to compensate the contract holder so AIG, the counterparty or company insuring the contract in some cases was now responsible. This placed AIG in a position where it has now borrowed $150 billion dollars from the Fed.

There is no easy solution to the current economic conditions our Nation is facing but creating more liquidity and allowing the Federal Reserve to ease monetary policy to levels that fostered malinvestment in the first place is no solution. The market must be allowed to correct itself and a recessionary period has to be tolerated in order for us to emerge a stronger more economically sound nation. The federal deficit has increased by nearly $1 trillion dollars in the last 30 days, the federal bailouts of financial institutions and the gross spending of money have done little to support economic growth, foster savings or support equity market prices.

There are consequences to all actions and the outright printing of money with no sound backing and the accumulation of unsustainable amounts of debt will lead to inflationary pressures that have never been experienced in our nation. We must work to protect main street and the citizens of this great country. The way to do that would be by ensuring that saving money is safe and that the value of our currency is sound, tangible and properly managed. That savings will ultimately lead to capital creation, economic growth and more sustainable levels of prosperity.