Wednesday, April 25, 2007

The Moral Implications of Excess Liquidity

25 April 2007

Excess liquidity is an economic concept that has been discussed several times on this site. Austrian Economics postulates that when the bank rate of interest is held lower than the natural rate of interest, then investment capital in an economy will become increasingly misallocated, leading to a series of relatively predicable and extremely serious economic problems.

That sounded dry and theoretical didn't it?

Let me bring that idea alive for you.

Let’s imagine you are the parent. Your child makes a poor or irresponsible choice. Rather than permitting your child to face the consequences of that choice, you provide an easy way out.

Perhaps your child wants a shiny new bicycle. You offer to share the cost, if your child will work and save to pay for half. But your child puts that off, and finds other things to do that are more interesting than working and saving. So… you buy the bicycle anyway, perhaps as a birthday or Christmas surprise. Your child has happily learned that rewards occur with little or no effort devoted to achieving them.

You have eased your expectations and rewarded your child for a level of effort that fell far below that which you originally expected.

Excess liquidity is about easing – specifically “monetary easing.” Run a Google search on that topic, and you will find considerable information about the Bank of Japan, whose post-bubble monetary easing over the past two decades has been the primary driver of global capital markets through the “Yen carry trade.” Search further, and you will find references to the US Federal Reserve Bank and to such names as Alan Greenspan and Ben Bernanke.

With any research at all, you will discover that stock markets rise when monetary easing is anticipated, and they fall when monetary restriction or tightening is anticipated.

Why is that?

Here is the shorter version (believe it or not).

About a century ago, the US government decided to take control of interest rates associated with the loaning and borrowing of money through the creation of the Federal Reserve System (sometimes referred to by its constituent parts as the Federal Reserve Bank or Board). This singular initiative took interest rates out of the control of free markets and placed them in government control.

As you may have noticed, politicians like to get re-elected. Over time, our politicians discovered that when the Federal Reserve Bank eased the supply of money by lowering interest rates, economic activity tended to increase. Jobs were created, and people felt generally prosperous. They had a magical formula for success.

When the Federal Reserve Bank lowers interest rates, the cost of borrowing drops, and private individuals and corporations will tend to borrow more money to undertake expenditures that they might not otherwise have considered prudent or affordable.

With interest rates low enough – as they were in the United States following September 11, 2001 – business projects that might have been uneconomic become marginally profitable. Why? Because the money to finance such speculative projects can be obtained almost interest free.

In fact, when you allow for the impact of inflation on the value of money, at some point it becomes cheaper to borrow money and to pay it back further in the future at very low interest rates, by using dollars that have become substantially devalued.

That is, at some point – when interest rates are low enough – banks are essentially giving money away to entrepreneurs and citizens, who may have to pay back less in real terms than they originally borrowed. (That has been true in Japan for perhaps two decades, though the Japanese economy fell into deflation, which is another story altogether. A similar situation occurred in the United States following September 11, 2001.)

When the Federal Reserve Bank initiates this process by giving away US dollars essentially for free, it is able to increase the amount of US dollars in circulation by selling treasury bonds to investors and savers (now usually foreign) who exchange their own currency for US dollars. This is referred to as increasing the US money supply. When the money supply grows faster than the production of goods and services, this leads to excess liquidity, the topic of today’s post.

OK, so far so good. But remember, we now have politicians overseeing the institution that sets the market interest rate (making our lending market controlled rather than free – an important distinction). Further, we have politicians promoting policies which increase the money supply, promoting a general environment of monetary easing.

And we have a vast populace casting their votes for politicians who make monetary conditions easy for them, rather than restrictive.

Sounds great so far, doesn't it? Who wouldn't want to make more money just by printing it? Let’s all share in the good times.

But the good times are not so good beneath the surface. In fact, a far-reaching process of decay sets in. Let’s think about that now.

Remember the child with the shiny new red bicycle?

Another year has passed, and the bicycle hasn’t been well cared for. It is now dented, rusty and clunky. The child wants another, newer, better and bigger bicycle. Once again, the indulgent parent provides the new bicycle with no expectations of the child. The old bicycle is discarded – and the cycle of easing (as it were) repeats itself.

How do you think this child, accustomed to a series of shiny new bicycles, is going to behave as an adult? I don't think you need me to advise you on this matter. We now have a spoiled and irresponsible child morphing into a self-indulgent and undisciplined adult.

And, what do you think might then be the moral implications of excess liquidity?

Let me walk you through a few of the more subtle permutations, then I'll set you free to think this through further on your own. If I achieve my goal, you will begin to see the world around you in a new light.

The following chart examines the growth of US MZM money supply (one of the better still-available measures) from 1980-2005. Is the trend apparent to you?

You are looking at growth from $1 trillion to $7 trillion US dollars in circulation during that time period.

OK, what if we go back further?

A more comprehensive measure, M3 money supply, increased from $250 billion in 1960 to almost $7 trillion in 2001 (and it has continued to balloon since then, to the extent that the US Federal Reserve Board is no longer willing to report this highly damaging statistic).

I think you're getting the picture now.

I told you that when money is given away easily, people borrow more – after all, it’s almost free! Here is what has happened to US debt as a percentage of GDP since the institution of the US Federal Reserve System in 1913:

Interestingly, in our present environment of monetary easing, US debt has never consumed a higher proportion of US GDP than it does today, including at the height of the great depression in the 1930’s.

So, you may ask, we’re still saving aren't we? In fact, the answer is no. The US savings rate actually moved into negative territory in 2004. Americans in aggregate are in fact now saving nothing at all.

You might then ask: Isn't all that liquidity making us richer? We've never lived in bigger, better houses or driven better cars than we do now, have we? We've never had more of so many things at often-declining prices?

Well, excess liquidity might cause us to feel rich, but the feeling of plenitude is driven solely by debt. That is, we are living a richer lifestyle than ever before, but we are selling our furniture for income, and burning the walls of our homes to keep warm.

The following chart shows that there is a small problem with printing money to generate wealth. US money supply in absolute terms has grown 32 times since 1959, but industrial production has increased only 4 times. That is, We have to print 16 times as many dollars to fuel twice the productive capacity of the industrial economy.

Why is printing money so ineffective in driving real economic growth?

Let’s think about that.

According to the Austrian School of economics, the core problem is that when our governments start giving money away, a cascade of vexing and inevitable problems begins to unfold.

The first and most serious is capital misallocation. In a restrictive monetary environment, it is highly risky to make new business investments as the cost of capital is high, and thus profitability must be substantial to sustain a new or expanded business. That sounds tough, doesn't it?

But here is the rub. A restrictive monetary environment provides discipline so that only well-conceived business ventures actually thrive. Half-baked and non-viable ideas flame out in the very early stages when the return on capital fails to match or exceed the cost of capital. Comparatively, far less capital is lost on fruitless or unproductive ventures.

That is, when economic conditions are tight, we have to work hard for our bicycles, and they might not necessarily be big, bright, shiny or even new. This restraint keeps us disciplined, focused and hard-working.

What exactly do I mean by capital misallocation?

Well, as we are in perhaps the greatest age of excess liquidity in world history, let me reply as follows – look around you – anywhere.

Capital misallocation is in evidence in almost everything you set your eyes upon today.

Our homes are too big, expensive to build, and expensive to operate (and many US citizens in particular cannot afford to pay for the homes they presently occupy).

Our productive capacity in almost every field of business is too great. We are producing too many computer and memory chips, too many cars, too many flat screen TVs, too many malls and shops, too many hotels and casinos, too many unnecessary luxury products, and too many consumer products generally.

Our debts have escalated to mountainous heights, and our savings have plummeted to subterranean levels.

Further, Americans can no longer afford to pay for the (unsustainable) activities of their government, the excessive investments of their corporations, or their personal consumer acquisitions.

Americans are presently borrowing 700 to 900 billion dollars per year from foreigners to finance their government, business and personal expenditures. Fortunately, because we are now producing too much of everything globally, prices have lowered, and Americans can finance this extravagant lifestyle by purchasing manufactured goods from overseas.

(By the way, Canada's situation is quite different at this juncture, though we have similar excess liquidity problems to those of the United States, because we are selling commodities as well as finished goods to the world. That is, Canada lagged while producing underpriced commodities while liquidity gradually mounted, and is now catching up again as liquidity has exploded.)

There is one small downside. The practice of relying on cheap labour overseas places us further in debt to foreigners. In fact, Americans are losing ownership of their country at a faster clip than has ever occurred in the country's history.

The United States was a net lender to the world from its inception until the rise of our present age of excess liquidity. A back of the envelope calculation indicates that Americans have already sold out about $3 trillion in ownership of their country to foreign holders of US dollar denominated securities (net external debt), and most of this transfer has occurred in the (current) first decade of the third millennium.

The United States owes the Japanese about $1 trillion, and the Chinese now over $1 trillion, and they are the two largest holders of US dollar denominated debt. Add another $1 trillion or so of US dollars in other foreign hands (including Canadian), and you will find that about 10% of the total value of all American securities (valued at $33.4 trillion in 2004), and obviously a rapidly growing percentage of all of the assets in America today, actually now belongs to non-Americans. Further, foreign holders of US debt now command over 30% of the $9 trillion US dollar money supply, and they are now adding to their investment in this United States fire sale at a rate of almost $1 trillion per year (equivalent to the annual US current account deficit).

Perhaps it is now becoming obvious that the only way Americans continue to own anything at all is by printing still more dollars, and that practice has not abated.

This is the era of monetary easing, and we all want a shiny new bicycle for every special occasion, and we will accept nothing less.

I suspect that the current trends are unsustainable, and that is why I have vocally advocated holding savings in gold and silver – as these traditional stores of wealth are preserving value while the worth of our currencies precipitously declines.

(By the way, gold and silver are advancing against every major global currency at present, so it is really a competition to determine which country will devalue its currency fastest. The United States seems the clear winner by far in that regard at the present time, due to its originally hard-won role as the largest by far of the world’s economies – unless it is compared to the European Union as a whole, which is about the same size. The Chinese economy, despite its breakneck growth and much larger population, is on less than 20% the scale of the US economy in GDP terms.)

What then are the moral implications of excess liquidity?

Let’s start at the government level.

We have a nominally “conservative” Republican government in Washington, D.C. which believes it can finance foreign wars by record levels of government debt accumulation while also cutting taxes. The Iraq war, like our transfer of assets to Japan and China, is rapidly becoming yet another trillion dollar US project.

Right or wrong, the United States simply can't afford the Iraq war… and it is not very bright, new, shiny or otherwise attractive at this point in its evolution. Similarly, we can't afford to fund the essentially non-productive US military industrial complex at its present level of full-bore operation in the background of the Iraq misadventure.

Americans have just floated their way through a classic stock speculation bubble of historic proportions in the year 2000, and the US real estate bubble began to implode in 2005. This latter speculative bubble will now be winding its way downwards for many years more, if not for decades to come.

US stocks are not worth 20 times earnings and more when one considers that their earnings are transient and of low quality (sustained primarily by record levels of consumer debt and household equity extraction). When earnings fall off a cliff, the present somewhat elevated US equity market price to earnings ratios will appear to be products of fantasy alone. They will be seen as attempting to soar in stratospheric realms with no means of ongoing propulsion.

US homes are worth no more and no less than what the next buyer will pay for them. It is no secret that there are fewer and fewer buyers every month for now very high-priced US homes, and it is virtually certain that there will be fewer buyers next year, and again the year after that.

Japanese real estate lost half its value following its bubble period, and has not recovered its value in the two subsequent decades. A similar outcome is probable for the majority of US real estate investments (there may be some exceptions, but that is not certain).

When we spend money we don't have, commodities move up in price to match the amount of money we have, accounting for the now just-beginning generational surge in commodity prices. Note how the following chart illustrates the close match between US dollar money supply growth and US dollar oil prices:

Again, the cost of what we buy rises to the level of the amount of money we have.

Thus expanding the money supply doesn't in fact make us richer at all. It redistributes wealth, and tends to do so in ultimately unfair and quite disturbing ways.

This disruptive and arbitrary redistribution leads to the core moral problems associated with excess liquidity.

When prices are stable, we are generally content with what we have.

When prices are rising – as they always do when liquidity increases – we now have to struggle to keep our share, or perhaps to get a few steps ahead of our neighbours.

It is no secret that those who struggle best for wealth when it is being redistributed are those who already possess it, and this fact accounts for the oft-noted mounting imbalance between the richest and the poorest Americans.

In an environment of monetary easing, savings accounts produce low interest rates, and inflation erodes their value often to the point of negative real returns. So people are forced by such an environment to engage in increasingly speculative activities with their hard-won income and savings.

Money becomes something to get rid of before it loses further value.

What does this redistributive environment produce?

Stock market bubbles. Real estate bubbles. Surges in gambling activity and casino construction. An increasingly unstable social and cultural environment. And increasingly irresponsible – and immoral – private citizen, government and corporate behaviour.

What do I mean by this last assertion?

Corporations have become cabals of CEOs who award themselves outrageous bonuses and stock options with little if any thought to the creation of shareholder value. Any form of deception to drive the stock price up the next notch will do. The stock market rises as the value of the US currency collapses. Equity analysis become cheerleading. There is little if any accountability anywhere in the corporate world.

Further, business now becomes a process of winning government favour and of using government contacts to constrain your competition while securing your own advantage. (Historically, this constitutes a return to the mercantile system and the ultimate decline of the free market system.) One need only speak the name “Halliburton” to illustrate this point, but Halliburton’s Iraq-based contracts are but the tip of the iceberg of an increasingly government-dependent corporate world.

From government subsidies to grow corn for ethanol production (forcing Mexican peasants to forego corn as the staple of their diet) to government bailouts of speculative investment firms (think Long Term Capital Management – who lost too massive an amount for the government to allow the losses to be absorbed by shareholders) to government subsidies for favoured business ventures of all kinds – every company is forced to find its edge with government so that it can play to win in an increasingly unlevel, distorted and ultimately surrealistic playing field.

And what of our money that is finding its way overseas to buy inexpensive manufactured products and increasingly expensive but necessary commodities?

Interestingly, the Chinese and the Japanese are deeply invested in the game of excess liquidity, and both are playing to win – with the result that they don't want to sink the US boat by selling out their excess of US dollars. Due to a shared vision of convenience, these countries remain America's paradoxical monetary allies.

But it is another story in Latin America, Africa and the Persian Gulf states, where anti-Americanism is literally being funded with US petro-dollars. America is bankrolling its own enemies by flowing excess funds to unstable oil-producing nations whose leaders and/or citizens are literally rewarded for their increasing hostility to the United States.

I have written earlier that the flow of excess oil funds into the Islamic world is in fact the primary stimulus for Islamic extremism and jihadism. When too much comes your way too easily, it is destabilizing, rather than opportunity-producing.

Those who have little or no experience of the generations of hard and exhausting work required to bring about free market growth have correspondingly little appreciation for the rewards of the free market system, including freedom itself. So the funds of the formerly free are being transferred at a rapid rate to many who do not know, appreciate or respect the hard-won prizes of social liberty or economic freedom, and this is much to our detriment.

Lastly, what of our own moral fibre in the present environment?

As has often been noted, philosophers throughout history, from as long ago as Plato’s time and before, have bemoaned the deteriorating moral standards of their youth.

Does this mean that young people in Plato’s time were no different that those in our time? Perhaps. But this begs the question, have kids always been the same in all ages?

I don't think so.

Let me posit an alternative explanation. Excess liquidity has preceded if not engendered the fall of virtually every human civilization throughout history, and as excess liquidity has weakened the fibre of the citizens of every empire, it has played a key role in the behaviour and the personal and moral standards of citizens in every generation.

(For more on this historical perspective, read Marc Faber’s Tomorrow’s Gold or Bill Bonner’s Empire of Debt.)

Let me assert that in times of monetary restraint in free market economies, the general population grows inclined towards actions that are responsible and respectful towards their fellow citizens – for in these times, the citizens of all nations require their fellow citizens to survive and prosper against ever-present adversity for the commonweal. And in such times when citizens are better behaved, their children are better behaved as well.

When monetary easing makes the flow of monetary liquidity excessive, and therefore too easy, our personal standards deteriorate. While this trend is perhaps most visible in our children – recognition of these moral changes is of greatest import for ourselves.

To return to my original example. You are again the parent (or perhaps the chairman of the Federal Reserve Board). Your child wants a shiny new bicycle (your voters – citizens and corporations – pressure you in every imaginable way for tax breaks and monetary easing). You do… what?

As you can see, the choice remains ours – to say no to easy money, and to its inevitable results: excess liquidity, excess debt accumulation, capital misallocation, ultimate economic decay and/or collapse, and, above all, inevitable associated moral compromise and decline.

Strong nations are built upon monetary discipline. Those who weaken their monetary foundations imperil the survival of their culture and civilization itself.

(Thanks are extended to the many public domain sources who have provided the charts utilized for this article.)


  1. Very well written and understandable.

  2. The Center for Media Research has released a study by Vertical Response that shows just where many of these ‘Main Street’ players are going with their online dollars. The big winners: e-mail and social media. With only 3.8% of small business folks NOT planning on using e-mail marketing and with social media carrying the perception of being free (which they so rudely discover it is far from free) this should make some in the banner and search crowd a little wary.