(I am an occasional contributor to roundtables of economists in the magazine The International Economy. This month’s topic was the possible dangers of “today’s giant swirling ocean of liquidity”.)
Imagine a city that experiences a miraculous improvement in its transit system. Thanks to some mix of new technologies and organizational improvements, the subways and buses are now able to carry far more passengers at lower cost and the same level of service. Would we see that as good news, or as bad? It’s true that Uber drivers and gas station owners would be unhappy as abundant public transportation reduced demand for their services. And retailers and restaurants might face challenges in managing a sudden flood of new customers. But no one, presumably, would think the city should deliberately give up the improvements and return transit service back to its old level.
The point of this little fable should be obvious: liquidity, like transportations services, is useful. Having more of it is better than having less.
What liquidity is useful for, fundamentally, is making promises. It functions as a kind of collective trust. The world is full of socially useful projects that can’t be carried out because even a well-grounded expectation of future benefits can’t be turned into a claim on resources today. Liquidity is the fuel for these transactions. In a world of abundant credit and low interest rates, it’s easier for me to turn my future income into ownership of a home, or a business to turn future profits into new plant and equipment, or a government to turn future revenue into improved public services.
Someone with a great business plan but no capital of their own might try to get the labor and inputs they need to bring it about by promising workers and vendors a share in the profits. Unless the business can be launched with just the resources of immediate family and friends, though, it’s not likely to get off the ground this way. The role of the bank is to allow strangers, and not just those who already know and trust each other, to contribute to the plan, by accepting — after appropriate scrutiny — the entrepreneur’s promise, and offering its own generally-negotiable promise to the suppliers of labor and other resources.
Yes, when you make it easier to make promises, some of them won’t pan out. But we would like people to make more provision for future needs, not less, even if our knowledge of those needs is less than perfect. The most dynamic parts of the economy are the ones where there are the most risky projects, some of which inevitably fail.
Of course asset owners are unhappy about lower yields. But that’s no different from the complaints we always hear from incumbents when production improvements make something cheaper. Asset owners’ complaints are no more reason to deny us the socially useful services of liquidity than those of the proverbial buggy-whip makers were to deny us the services of cars. (Less reason, actually, given the concentration of financial wealth among the wealthiest families and institutions.)
Interest rates today are lower than at almost any time in history. So are the prices of food or clothing. We should see abundant liquidity the same way we see these other forms of abundance — as the fruit of the technological and institutional that has made us so much materially richer than our ancestors.
This completely inverts the relationship between interest rates and financial asset returns. Low interest rates permit high leverage by hedge funds and thus high returns. On the other hand, investment depends not on liquidity or low interest rates but on consumer demand.
I’ll try to explain my doubts with an example.
Suppose that we have case 0: a country with a net output of 100 muffins/year. Each muffin sells for 1$, so yearly circulating money is 100$/year. Also muffins are produced by factories whose cumulative value is 50$, and those factories have been financed by debt, so that there are also 50$ of debt in the whole economy, and on the other hand the creditors of these facories own 50$ in credit that represent the whole of savings.
Now there are various possible evolutions of this situation.
Case 1: the quantity of muffin produced increases or decreases, at constant prices. If the quantity of muffins increases to 200 muffins/year, then circulating money also increases to 200$/year; presumably also the number of factories increases so we get to 100$ of factories and 100$ of debt/credit; on the other hand if the quantity of muffin decreases at fixed prices some factories will close down, and the credit associated to them will disappear (this is what happens in a crisis).
Case 2: the quantity of muffins and factories stays the same, but for some reason the price of muffins changes. If the price increases to 2$, we have inflation, the circulating money also increases to 200$; the price of the factories will presumably also double due to inflation; the amount of savings nominally stays the same and thus in theory real savings are halved, however people will save more in nominal terms due to inflation, and the factoriers will be renewed at some point at inflated prices (since the 100 muffins are the net output, not the gross output, so there is also obsolescence and renovation of capital goods in this example), so at some point savings will also double again, although it will take time.
If instead we have deflation and the price of muffins falls to, say, 0.5$, the factory owners will find themselves overindebted and will go to bankruptcy, savings will disappear but factories will be re-sold at new prices, so after a big crisis we get again to the same situation as before.
However there is also another option, Case 3: the quantity of muffin stays the same, the price of muffins also stays the same at 1$, but the price of the capital goods increases for some reasons, for example because people want to save more and this brings down the interest rate, but such reduction in the interest rate doesn’t lead to new factories but only tho the current factories increasing in price.
In this situation, circulating money will stay at 100$/year, but total debt/credit will increase to 100$ so we have a debt/ndp ratio that icreases from 50% to 100%, and arguably the economy becomes more crisis prone, as a small change in the prices of this or that product can cause a big bankruptcy.
Now these 3 cases can happen contemporaneously, so it is difficult to distinguish between the 3 effects, but it seems to me that the problem of financialisation and, perhaps, low interest rates is case 3: we get to a situation where the debt/circulating money (or savings/circulating money, it’s the same) increases continuously, and in fact the whole economy, being demand-starved, is depending on the continuous increase of debt, an increase that is faster than the increase in circulating money.
Since most people who worry about easy money worry about case 2, this sorta flyies under the radar, and in fact the problem is perceived as the opposite of what it really is: inflation at least in the immediate reduces the savings/circulating money ratio, so stabilizes the economy, but in reality even with high inflation we see constant increases of debt/gdp ratios, so the real problem is case 3.