Liquidity: Toward a Proper Mechanism

I have promised a treatise on the proper regulation of liquidity in the economy from a perspective of avoiding both speculative credit bubbles and deflationary credit collapses.

There have also been those who disagree with my definition of "money." I will therefore remove that term entirely, since "money" connotes different things to different people and we'll go through the definitions again:

• Asset: An item that has value of some varying amount of stability. Examples are a stand of trees, a stack of sawn and finished lumber, a bushel of corn, a house, a car, a CNC machine and a computer.
  
  
• Currency: An abstraction of a collection of assets, also of varying value against those assets. Often used as a medium of exchange between parties who wish to exchange one asset for another, and sometimes used as an abstracted store of value. Examples include federal reserve notes and quarter coins. Some forms of currency are officially backed or mandated for certain uses, but not all.
  
  
• Credit: A further abstraction of currency, but generally fungible with currency in commerce. When brought into existence backed by an asset, credit is "hard" or "secured"; when not, credit is "speculative" or "unsecured." Credit always, in some form, requires payment of interest.
  
  
• Interest: The amount one pays for the use of credit, usually (but not always) denominated as a percentage. The elements of interest are the risk of failure to pay, the risk of debasement of the unit credit is denominated in, the scarcity of credit and the demand for profit on the lending transaction.
  
  
• Liquidity: The amount of currency and credit in an economic system that is available for deployment (that is, is not committed to some other purpose) at any given point in time.

From this we can determine certain relationships:

• The greater the system liquidity the lower the rate of interest, all other things being equal. That is, the more "free and uncommitted" currency and/or credit is available, the less will be charged for its use in recognition that credit follows the classic economic supply/demand curve.
  
  
• The greater the interest charged the less deployment of credit will take place, and the greater the preference to use credit for productive purposes. As the cost of credit rises its use for speculative or consumptive purposes becomes less desirable compared to saving the funds required prior to their expenditure. Likewise, the lower the cost of credit the more likely it will be used to pull forward demand (consume) or speculate.
  

It is generally-accepted that significant inflation or deflation are undesirable.

During significant inflation goods become more expensive relative to incomes. If there is sufficient labor pricing power to force coupling of these price increases back to wages, then a wage-price spiral ensues and can quickly get out of control, since labor is the predominant cost for most businesses. If there is insufficient labor pricing power to force coupling of price increases then the standard of living degrades for the citizens, in severe cases sufficiently to force a material part of the population into abject poverty.

Significant deflationary events, on the other hand, bankrupt debtors as the real value of the currency used to pay their debts rises rapidly. This can quickly overwhelm their ability to pay, even when that debt was acquired for legitimate productive purpose. When these entities fail they discharge workers, forcing contraction of GDP which can in turn lead to further insolvencies as purchasing power declines in the population. This too can become self-reinforcing and lead to significant economic dislocation.

It is often claimed that "hard money" is a natural check and balance on the tendency of fiat currency regimes to "run away" into an inflationary mess as a means of "printing" out of sovereign debt. The alternative, however (hard money), has a many-hundred-year history of causing forced inflationary and deflationary spikes that are extremely harmful to the economic climate of any nation, as is shown by the following chart found on Wikipedia:

The inflationary and deflationary spikes are caused by the nature of "hard currency"; once dug out of the ground gold, for example, is not destroyed. When innovations in productivity outrun the ability to provision new currency reserves deflation ensues as the mining rate cannot keep up - the resulting deflation causes business and personal bankruptcies. This in turn causes a contraction in GDP but that cannot be balanced with a withdrawal of the currency base since it already exists! The result is a punishing swing between severe bouts of inflation and deflation; this is unacceptable.

Yet the history of our fiat money regime as practiced to date, while perhaps "better" in terms of violence, certainly isn't in terms of bias, which is clearly inflationary, all the time.

Why?

Simple: Given the proclivity of "choice" the monetary authorities will always choose to try to paper over their friend's mistakes! This requires inflation, not deflation.

Unfortunately such "papering over" ultimately leads to either a Weimar-style collapse or the utter destitution of huge percentage of the population, dependent only on whether wage-price coupling can occur. As inflation is a "silent tax", so long as it does not happen too suddenly people tend to react much as a boiled frog - that is, they don't realize what's going on until they're cooked!

There are two competing issues - if you permit debt to rise faster than GDP over an extended period of time you will inevitably get a "runaway" condition and deflationary credit collapse. This occurs because of the mathematical reality of exponential ("compound growth") functions and no amount of tampering can change it if these relationships are maintained. The following chart demonstrates this phenomena:

But regulating liquidity and thereby preventing this outcome and what is otherwise a mathematically-certain outcome can be done through a ministerial process. Let's go back to one of the charts I recently introduced - the Market Ticker Ponzi Finance Indicator:

This indicator is simply the arithmetic difference in growth rates between GDP and systemic credit outstanding. If this indicator is positive then GDP is growing faster than (or shrinking slower than) credit in the system. If it is negative the opposite is the case.

When the indicator is positive systemic stability in terms of debt coverage is improving, and likewise it is deteriorating when negative.

Since the goal of liquidity regulation is to maintain systemic balance in debt coverage the mandate to be provided as a matter of law to whatever entity regulates liquidity in the monetary system is simple: The Ponzi Finance Indicator must be slightly positive.

Implementation of this mandate is relatively simple, in that excursions beyond a modest negative value (e.g. -1%) denote severe monetary imbalances and produce asset bubbles. The 1990s Asset bubble in Internet Stocks was produced by the severe imbalance in credit and GDP growth in the mid 1980s that The Fed refused to correct, and the Housing Bubble was produced by the continuation of that imbalance from the late 1990s forward. The Fed's current policy, indeed, has spawned yet another asset bubble, this time in stocks which are trading at a completely preposterous 140 P/E ratio as of the end of September 2009, or roughly ten times the historical "fair" valuation. While many will argue that this is an unfair computation given the negative earnings from last year the fact remains that these negative earnings were real; even on a "current" basis of the second quarter alone the P/E is 122. This bubble, like all others, will burst with disastrous consequences.

The solution to this problem is to place system liquidity regulation under a ministerial regime that is respondent only to the Ponzi Finance indicator (and to further mandate that GDP be honestly reported, as distortions in GDP will of course lead to improper adjustments), both as a matter of law. This will result in credit tightening on an automatic basis as long as credit growth is exceeding economic growth - that is, so long as market actors are using credit not for investment but rather to engage in ponzi-style consumption measured simply by the objective on-balance results of credit and output rates of change.

Such a change in policy measure will put a permanent stop to the policy of "bailing out" financial institutions through lowering interest rates at the precise time when they have engaged in Ponzi-style financial maneuvers, creating unsustainable credit. It is precisely this cycle - the political demand to "cover bad bets" made through Ponzi-style financial manipulation, that ultimately, if left unchecked, leads to deflationary credit collapses or even destruction of a nation's currency.

Fiat currency can work, but to do so the liquidity supply must be constrained such that credit growth is never allowed to outpace GDP. Simple sixth-grade mathematics prove this to be the case, and also prove that when this stricture is violated disaster will strike - we are left only to argue over how long we have before it occurs.

Those who argue otherwise, whether on the public or private stage, are committing fraud upon the public and must be held to account for their criminal acts.

Comments

[Jasper M:]

Careful, Karl - if you keep providing precise, Accurate definitions like this, you will give Fed & Treasury very little room for obfuscation, and then they won't be able to get Anything done.

Oct 08 03:33 PM

[Leftfield:]

I like it. I imagine there will be some of the same problems as with hard currency; this indicator will not yield when tough choices need to be made. Politicians and rentseekers will want to make just a few tweaks here and there, which will always grow and result in greed-induced disaster. Just one more hit off that bottle, even when the economy is in intensive care.

Oct 08 03:55 PM

[ryanclarke:]

Nice article and a good read. Adam Smith believed the wealth of nations should rest in the people of those nations and the commerce they undertook. Too bad, capitalism has, since the dawn of each nation, competed against nationalism and the right of the state to maintain control of the people. Time will tell which ideology will prevail in this country. It's been an ongoing two hundred year plus struggle but eventually capitalism will prevail, as capitalism mimics mother nature's supreme law of supply and demand. Bernake can control the supply and demand of money, forever, as the Fed has invented and put a patent on the printing press. BUT the more Bernake attempts to control money the less control he has of the supply and demand of natural resources. It's just a matter of time until the market corrects.

Oct 08 06:33 PM

[derryl:]

Greenspan and others have argued that bubble formation is too hard to spot. The Ponzi Finance Indicator is a good tool to remove this 'difficulty'. Karl is right: Grade 6 arithmetic is all that is needed to understand how money works, and how it doesn't. The hard part, as Leftfield notes above, will be getting the political and financial powers (and profligate borrow-and-spend consumers) who benefit from Ponzi finance to accept the discipline of this countercyclical monetary device.

Oct 08 06:55 PM

[Jasper M:]

On Oct 08 06:33 PM ryanclarke wrote:

> Bernake can control the supply and demand of money, forever,

Oh, don't be tooo sure of that - market responses to excess credit can destroy credit based money faster than the fed can create it, and actual printing enough physical $ to fill the hole of all that vanishing credit would take DECades!

Oct 08 08:03 PM

[Shishir Nigam:]

The chart showing historical inflation/deflation is very interesting. The pretty much continuous inflation since 1950 gives an indication as to how much the currency has been debased.

As I read your recommendation, something came to me. Isn't the Fed's (or for that matter, any central bank) main role supposed to be to increase the money supply on a very conservative 1-2% a year, in line with the growth in GDP, so as to avoid excessive inflation? MV=PY? If Y decreases while M increases big time, price HAS to go up by a greater multiple? (granted that V is going down a little bit right now)

Am I missing something? Did the people at the Fed not read their economics textbooks? Seems to me that their current actions are in direct violation of their other mandate - to maintain stable prices.

For more analysis, check out my blog: youngandinvested.com

Oct 08 11:13 PM

[ryanclarke:]

The Fed no longer acts in response to economic changes of the state ... but to enable the state to maintain control of the economy and hence the people ... nationalism ... which is due to the state's poor choice and implementation of foreign policy during the Bush years ... which Obama feels necessary to continue.

Oct 09 12:47 AM

[FB5000:]

I see the circus is back in town and Clown Karl is back at it.

There a variety of "schools of economic thought" the current Orthodoxy breaks into two main parts; there is the Chicago school - the so called "freshwater" and the "saltwater "approach e.g. MIT. There are many others - the Austrian school, Marxists, and many more besides.

We must now add another: The Clown school. Karl is the leader.

PE's of 140 times?
You cannot talk about liquidity without discussing velocity
Inflation is bad to a matter of degree. Any deflation is bad. But what is disinflation? You don't mention it
You cannot talk about debt without discussing productivity. Debt is not all the same and not all bad, how? and why? Do you kow?
It seems that intellectual capital and know-how, ideas and other intangibles are not assets according to the clown school of economics.

Seriously, you were born 400 hundred years to late. Your ideas would have been on the money in the late 1500's. We have moed on from there.

Oct 10 09:54 AM

[Jasper M:]

On Oct 10 09:54 AM FB5000 wrote:

> You cannot talk about liquidity without discussing velocity
> Inflation is bad to a matter of degree. Any deflation is bad.

Not so. Not to those out of debt, and not depending on repayment of debts. I, for example, am very well prepared for deflation, and stand to profit handsomely. Those who have not, arguably including the nation a a whole, will learn an invaluable lesson, one which they have demonstrated a resistance to learning any other way.

The assertion that "deflation is always bad" is a blind acceptance of Keynsian sensibilities, by those who have lived under a regime of "government rescue by incremental currency debasement" for so long, they view the end of that possibility as the end of civilization. It is not the end. It is the beginning.

You started off with a promising reverence to velocity (a Much over-looked issue these days!), bu then descend into nonsense. The Clown is in your mirror!

Oct 10 08:04 PM

[Karl Denninger:]

What those who pray at the Keynesian Altar have missed is that velocity cannot be maintained when debt-carrying capacity is exhausted.

The problem with the monetarist principle MV = PQ is that "V" cannot be maintained when maintaining "P" and "Q" requires more debt issuance and there is no more credit capacity in the economy. The attempt to do so forces them to dramatically increase "M" (which Bernanke has done) but "V" has not responded nor has P or Q, because in a credit-based monetary system (all modern systems are) increasing base money is ineffective due to the multiplier factor.

This lesson was learned the hard way in the 1930s and everyone who learned it is now either dead or senile. We will thus get to learn it again.

Oct 11 11:51 AM

[Golden Oxen:]

No mention of Gold, and it's historic role of preventing the illegal fiat insanity that afflicts us?

Oct 12 10:01 PM

[Chumba Wamba:]

On Oct 12 10:01 PM Golden Oxen wrote:

> No mention of Gold, and it's historic role of preventing the illegal
> fiat insanity that afflicts us?

NOOOOOOOOOOO! Don't mention gold within earshot of Klown Denninger or else his head will explode and the mush inside his skull will end up all over your nice shirt.

Oct 14 01:01 PM