The Shaking Tower of Debt
The alleged "liquidity crisis"
The repercussions of the turmoil in the US subprime mortgage market are increasingly being felt around the world. What was initially thought to be a problem confined to a US credit market segment has increasingly transformed itself into an erosion of investor confidence in credit quality in general and, in some countries, concerns about the reliability of the banking sector.
The most obvious symptom of eroding confidence is the alleged "liquidity crisis." The term "liquidity" usually denotes the possibility to buy or sell a financial asset at any one time without causing noticeable changes in the price of the product being bought or sold. Market participants speak of "illiquidity" when it is no longer possible to sell financial products, or if selling is possible only at greatly diminished prices.
In recent weeks, a number of financial market segments have indeed become illiquid in the sense defined above. In the interbank markets, for instance, where commercial banks lend and borrow central-bank money, lending rates have risen to abnormally high levels over official short-term interest rates, reflecting increasing reluctance of banks to lend to each other (Fig. 1).
Fig. 1: Money market rates in the US and the euro area
In addition, concerns about credit risks have made investors increasingly unwilling to refinance maturing asset-backed commercial paper (ABCP) issued by so-called "conduits" (Fig. 2).
The latter were established largely by banks to open up new financing opportunities. Banks took on the role of "sponsors," that is providing conduits with credit enhancement or liquidity support or both. As of September 12, 2007, the total US CP market amounted to US$1,917.1 billion, thereof US$945.1 billion accounted for US ABCP.
Fig. 2. — US commercial paper market in US$ billion
Source: US Federal Reserve. The numbers are seasonally adjusted.
If ABCP issuing conduits draw down on their liquidity support, banks as principal providers of liquidity need to provide money either from their own internal resources or through borrowing from the money and capital markets. So in the current period of market strain, various banks' funding needs have increased because of their liquidity commitments vis-à-vis conduits.
What is more, holders of credits and credit-related derivative products find it increasingly difficult to sell their positions in the market. This is because investors have become rather risk-averse, refraining from seeking any additional exposure to credit-related financial assets.
It is against this background that markets are said to suffer from "illiquidity" — a term that would suggest that markets are no longer functioning properly. It also lends support to the notion that government intervention would be needed to get them going again. However, one may also take a different view, namely, that markets are in fact working pretty well, and that the term "illiquidity" is merely an anticapitalist propaganda term.
The market functions well
A free-market transaction — be it for real or financial goods — is a mutually beneficial contract between two or more participants. The buyer pays money for something he considers more valuable than what he surrenders. Likewise, the seller values the amount of money he receives more highly than the vendible goods he offers in return.
So if there is no buyer, it might signify that there is indeed no one who would want to exchange scarce resources against the product under review. Or it might signify that the money price for which the seller is willingly exchanging a vendible item is too high, but that there will be an exchange if and when he agrees to a lower price.
It would hardly be surprising that those who would like to sell their assets at a higher price than the prevailing market price complain about an "illiquid" financial market. In fact, such complaints might indicate that they have bought products at an elevated price or have recorded their assets in the balance sheets at prices that are above prevailing market prices.
Today's banks and institutional investors value their assets according to the "mark to market" principle. It requires investors, inter alia, to write down asset valuations against equity capital if their market prices are lower than the prices recorded in the balance sheet. Current financial market conditions therefore put a strain on the capital base of the financial sector — the extent of which is broadly unknown as of today.
A decline in equity capital might reduce the financial sector's willingness and capability to extend loans to the private sector. And given that the business cycle has been fuelled by an ever-increasing inflationary supply of credit and money in recent years, it would not take much to expect that a sudden slowdown of credit and money-supply inflation would be accompanied by output and employment losses.
A cyclical downturn would presumably be accompanied by a deteriorating overall credit quality. Loan losses would put additional pressure on banks' equity capital, diminishing their lending potential further. A downward spiral might be set into motion: declining credit supply, declining investment and consumption spending, and rising loan losses, which, in turn, reduce the banking sector's ability and willingness to extend credit.
It is against this outlook that complaints about an alleged "illiquidity" of financial markets, in particular the short-term money markets, have not been lost upon central banks. A number of major central banks — among them the US Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England — has increased the supply of central-bank money already.
By injecting additional supply of central-bank money, central banks want to prevent disruptions of the payment system and keep banks from incurring losses, as both events might trigger a widespread banking crisis, which would almost certainly have negative spill-over effects onto the real economy.
In addition to pumping money into the system, on 18 September 2007 the US Federal Reserve cut interest rates by 50bp, bringing the Federal Funds Target Rate to 4.75%. The Fed move is now putting increasing political pressure on monetary policy makers in other countries to embark upon a rate cutting course as well.
Of course, the current turmoil in financial markets is a symptom of a crisis-prone, government-controlled, money-supply monopoly. Central banks, in an attempt to artificially suppress the interest rate, keep increasing credit and money supply. The relentless rise in "circulation credit" — that is, credit created out of thin air — causes inflation, induces distortions in relative prices and encourages malinvestment, which, sooner or later, leads to an economic slump.
In this context, Ludwig von Mises wrote,
As soon as the afflux of additional fiduciary media comes to an end, the airy castle of the boom collapses. The entrepreneurs must restrict their activities because they lack the funds for their continuation on the exaggerated scale. Prices drop suddenly because these distressed firms try to obtain cash by throwing inventories on the market dirt cheap. Factories are closed, the continuation of construction projects in progress is halted, workers are discharged.
Too much credit, too much money
So as soon as an economic crisis comes closer, central banks — encouraged by a popular anticapitalist mentality — start pumping even more credit and money into the economy. In an attempt to escape the painful but economically necessary adjustment of relative prices, which could bring the economy back to equilibrium, central banks keep heaping one inflation boom upon another.
However, such a policy doesn't solve the underlying causes of the crisis. As Mises put it,
The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion.
No doubt, the costs of a return to "sound money" — that is ending the government money-supply monopoly and returning the supply of money to free-market forces — would most likely be substantial. It would most likely entail a severe loss in output and employment, given that inflation has been allowed to have a say in the allocation of scarce resources for decades.
To Mises, however, the only issue is whether the adjustment crisis is to be accepted today or postponed to the future, causing even higher costs:
The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.
The relentless rise in debt relative to income in most western economies — a direct outcome of central banks' relentless increase in credit and money supply — can be expected to shift public preferences, sooner or later, towards inflation: inflation becomes economically attractive to highly indebted groups. It might therefore be a growing concern about the soundness of the tower of debt the government-controlled money-supply regime has erected that has the money price of gold trending upwards.
Fig. 3. — US-dollar per ounce of Gold, nominal and real*, Jan. 1928 — Sept. 2007
 On August 17, 2007, the US Federal Reserve announced a temporary change to its primary credit discount window facility. The FOMC approved a 0.5 percentage point reduction in the primary credit rate to 5¾ percent, to narrow the spread between the primary credit rate and the FOMC's target federal funds rate to 50 basis points.