Friday, November 23, 2007

A Better Way to Understand Excess Liquidity

23 November 2007

Excess liquidity is a difficult concept to grasp.

Let’s try this explanation for simplicity:

In 1980, there were 1.8 trillion US dollars in circulation.

Now there are 13 trillion US dollars in circulation.

That is an increase of 722% in 27 years.

Is the US producing 7.2 times as many goods and services now as in 1980?

Of course not – the economy has grown, but not that much.

This means that, in fact, too many extra dollars have been produced during the past 27 years.

Who dishes out the extra dollars?

This is the designated role of the US Federal Reserve Board.

Who, therefore, do you conclude that Wall Street watches most closely? (a) The US consumer? (b) US business leaders? (c) The Chairman of the Federal Reserve Board?

If you guessed “c,” move to the head of the class!

The Federal Reserve Board is more important than either the US consumer or US business leaders in creating a flow of money in the country. And, by producing so many US dollars, the Federal Reserve Board has had a major role in enhancing the flow of US dollars around the world at large as well.

Now, what do you think happens when too many US dollars chase too few goods and services?

Great! You’ve got it again! It now takes more US dollars to buy the equivalent goods and services, and we call this “monetary inflation.” No wealth whatsoever has been created, we have just increased the number of dollars that are required to purchase more or less the same quantity of goods and services.

Are you ready for the next question?

How do these new dollars get distributed – after the Federal Reserve Board has dropped them out of a metaphorical helicopter?

You’ve guessed it again!

Everybody who is alert to this game scrambles to get their hands on them first!

And who watches this game most closely? You guessed it – the professional investment community!

Now – who do you think actually lays their hands on these excess dollars before anyone else?

If you guessed “Wall Street financial firms,” then keep your seat at the head of the class.

The denizens of Wall Street watch every move that Ben Bernanke (the current chairman of the Federal Reserve Board) makes, and every breath he takes. They read tea leaves to divine his every move!


Mr. Bernanke dishes out the excess dollars that the Wall Street players desire to get their hands on first – ahead of you, me, or anyone else.

Do you imagine that this is an orderly process?

Aha! You’ve guessed correctly again! The process is in fact quite disorderly – in fact, it is a mad scramble.

The financial professionals on Wall Street (figuratively – really the US and global financial services industry) engage in inventive processes to rake in the new funds as fast as they flow out of central banks around the globe (as central bankers almost everywhere engage in more or less the same process as the US Federal Reserve Board).

In the late 1990s, these “financial innovators” promoted IPOs (initial public offerings) of technology and internet stocks. More recently, they have capitalized on the liquidity-inflated housing market, creating “mortgage-backed securities,” “collateralized debt obligations” and off-balance-sheetstructured investment vehicles.”

They sell them to second, third and fourth parties down the line, charging significant fees in each case. Ultimately, the money that we invest in housing and mortgage payments flows through these vehicles. It is a game of hot potato – as the last one holding the hot potato (yet another over-valued and over-hyped Wall Street investment product) loses the game.

How do human beings feel – psychologically – when the quantity of money keeps increasing – and as the value of the money we hold in our pockets inevitably dwindles?

You’ve got it right! We feel insecure.

Case in point – the real rate of inflation is on the order of 10%. Let’s say your bank is paying 3-4% interest on savings. If you are a saver, you are losing, say, 6-7% per year. On a long-term basis, your savings will so substantially dwindle in value that you will not be able to guarantee a secure retirement.

Add to that the fact that your take-home pay is probably not increasing at a 10% per year rate to match the rising real cost of living.

How do humans respond to such a guaranteed losing game?

We enter into higher-risk games, attempting to protect and enhance the value of our diminishing (due to monetary inflation) assets.

In the 1990s and early 2000s, we bought internet and technology stocks.

Then as the technology and internet bubble faded, we increasingly bought homes (as a “real investment”) and risky investment products based on questionable mortgage loans to unqualified buyers.

Many Americans (in particular) pulled equity out of their supposedly ever more valuable homes in order to pay down other debts and to purchase consumer products (as saving had become increasingly counter-productive, spending was the remaining alternative for many).

International interest in casinos and other forms of gambling has exploded as the money supply has ballooned out of all proportion to the real growth of the domestic and global economies.


The gap between the rich and the poor in the US has increased to its greatest level in history.

The middle class has stopped participating in the wealth creation process.

Many speculators, borrowers and risk takers have lost much or all of their risk capital – and in too many cases, their life savings.

Chief executives of Wall Street firms have recently lost their jobs due to the emerging discovery of the worthlessness of the investment products they have been buying and selling (taking with them $150 million compensation packages, as well as the proceeds from commissions on the worthless pieces of paper that they had been buying and selling, often many times over).

Where did the $150 million packages come from?

Remember – that was the money that Mr. Bernanke – and before him, Mr. Greenspan – handed out – and which came back to Wall Street through mainstream investors’ purchases of hotly-promoted financial products (most recently, “creative” mortgages and home equity lines of credit, etc.).

What is the solution?

The increase in the money supply should not exceed the increase in production of goods and services – period.

Reining in money supply growth would bring the current madness to a screeching halt – initially creating substantial economic disruption – but ultimately allowing for the restabilization of financial, real estate and other markets, thereby – somewhere down the road – making saving worthwhile again – and financial speculation and risk-taking considerably less attractive.

What would it be like on Wall Street in such an environment?

At first, it would be like watching paint dry, there would be almost nothing for the Wall Street professionals to do, and many would leave the business as the commissions and speculative gains evaporated. But gradually, over time, there would re-emerge an honest business in selling much more modest and straightforward investment products of real value to American and global investors.

But that is not here or now. Not yet. Not for many years to come.

We have to wring out the excesses of the current glut of North American and global liquidity.

This wringing out will be a lengthy and painful process. But its eventual outcome will be positive – normalizing and restabilizing our economic system – at a much scaled down pace and scope of operations.

What to do here and now?

Gold and silver remain wise investments when the financial system is insecure, though their volatility (in terms of unstable US and other world currencies) will continue to reflect the vagaries of wide-ranging and often irrational human sentiment.

Buy gold and silver and diversified shares of the mining companies that produce them, gradually, fewer ounces and shares when prices rise, and more ounces and shares when prices fall. Over time, the value of precious metals and mining companies will certainly rise, and you will be well-rewarded for your self discipline and longer-term vision.

I am hopeful that this brief lesson may prove of value to you…………………


  1. The bubbles are so pretty!

    Seems to me bubbles are always attractive and that is part of the problem.

  2. Yes, superficially so. The downside, which is the destruction of value of savings, is not immediately apparent to the average citizen. Eventually the destruction of savings discourages capital investment, as business activity can no longer keep pace with liquidity creation as a source of so-called "new wealth." Gradually, everything becomes a casino, or turf for competing gangsters. In the final stage, the currency collapses (we're not there yet, believe it or not), and rationality returns based on the collapse of the Ponzi schemes (the bursting of the various financial bubbles). Unfortunately, the liquidity game can be drawn out years longer than seems rational.

  3. Now that the Reserve Banks have supported the banking system with "real " assets and perhaps supported certain stocks in their respective countries, what will result ?

    Its plain that the people have been dumped with this debt and it will cost.

    The huge Globs of transfered assets must translate as liquidity at some time with printing requirement.Thats a sizable inflationary experience !!??!!

    Laurence you may be able to put some figures to the current size of the Feds rescue and also to estimate the inflationary effect etc.

    Its a substantial rescue I believe and should impact the price of Gold etc.

    Nice site, nice presentation. I have much to discover as yet.

  4. Thank you for the compliment.

    I posted later that the current bailout estimates are in the hundreds of billions, but the Iraq War estimates were on that scale at the outset as well.

    I'd say this is on the scale of the Iraq War, it will be counted in trillions of dollars before the bailing out is done and the currency is discredited.

    Such trends take years to unfold - literally a slow-motion train wreck - though markets are anticipatory, and often read this in advance as well.

    That is, the markets may figure this out before too many trillions have been logged on to the taxpayer bill.