Sunday, August 31, 2008
The Weird Answer to Excess Liquidity
The loose lending standards and the low rates of the past few years are collectively known as "excess liquidity". In traditional central bank fashion, this is to be generally avoided since the tail end of a long period of this brings nasty consequences.
The severity of these consequences is partially dependent upon the length of time the excess liquidity was available, plus the corresponding reaction of both the central banks, commercial banks, investors and the public reaction itself as the liquidity is drained off.
In the 1970s, the drain of excess liquidity meant markedly higher lending rates, as inflation began to soar in response to the excess liquidity. Lending rates, in most industialized countries, continued to rise, until inflation was defeated in one last hurrah, as the earliest part of the 1980s dawned. A decade long battle that ultimately required lending rates in the 15-20% range to defeat.
Now, it appears, the answer to excess liquidity is this: raise rates to something beginning to resemble normal long-term banking averages - and watch the banking system begin to wobble, wobble, wobble. When the time is ripe (or some critics argue, over-ripe), introduce the forebearer of excess liquidity (low central bank rates) to deal with the number of weakened banks. This will allow some of the (less) reckless banks to repair their balance sheets, the strong to get stronger (and thus buy out some weak competitors) and for, more generally, faith to be restored in the system.
So the answer to the 2000s excess liquidity situation is - more liquidity.
Further explanation, here.