Economics and Liquidity

by Michael J. Howell3. January 2014 11:27
Liquidity can be thought of as money serving as means of purchase, i.e. funds that 'start' the monetary circuit. Keynes realised that in a Capitalist economy liquidity and not savings determine the volume of investment, and reinforced later by Kalecki, that investment rather than consumption is the key dynamic behind profitability and economic growth. Liquidity has real effects because it changes the structure of production by increasing duration through portfolio effects and in the process raises the demand for long-dated financial assets, such as equities. Conventional economics not only muddles this by focussing on money as means of settlement, i.e. funds that 'close' the circuit, but it also confuses the price of money --the exchange rate -- with the cost of credit -- the interest rate. Interest is a category of profits and has little or nothing to do with monetary policy. However, attempts to 'fix' interest rates and ignore or 'float' exchange rates always creates instability. Thus, ever since the 1971 end of Bretton Woods and the more recent attempts to straightjacket interest rates into a Taylor Rule, the financial system has suffered a near regular 8 1/2 year repeating cycle of boom and bust. For example, markets saw peaks around end-1973, mid-1981, early-1990, mid-1998, early-2007 and should again around mid-2015. Within around a year of each peak they fell heavily. The way to mitigate the cycle is to stabilise exchange rates, not interest rates. Because liquidity is dominated by credit, the monetary system is debt-based and leveraged. Collateral becomes vulnerable when debt-repayment is compromised and so liquidity becomes hugely pro-cyclical. What's more, since in a crisis the only true collateral is legal tender aka Central Bank money, leverage can be extreme. After having moved down through 2007 and 2008, collateral and liquidity have been together moving up since 2009, helped by Central Bank QE. They still have a bit further to run, but be warned what goes up inevitably comes down. A 2016 Crash perhaps?


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