Friday, September 19, 2008

Liquidity = Solvency

I'm struck by how, for financial firms in a fractional reserve system, there really is no difference between "liquidity" and "solvency". It's hard to nail down what "liquidity" means. With all this talk of dollar injections I imagine a sort of green juice in a giant hypodermic needle that will jab the rump of the financial system -- wherever that is -- and somehow make everything good again. But this is bogus.

The most meaningful sense of the word "liquidity" is the ability to use short term deposits as collateral to make long term loans. This is at the heart of fractional reserve banking, and it is a system that is inherently unstable, like a naked singularity, or a pencil balanced on its point. It is inherently unstable because it has two equilibria: 1) everything works (lenders do not pull out their deposits en masse) and 2) the bank collapses, because there is a rush for the exit. The slightest stochastic fluctuation can trigger a switch reversal from state 1 to state 2. There is no single, Nash equilibrium. The switch from 1) to 2) is discontinuous and chaotic -- it falls into Taleb's fourth quadrant -- so it cannot be effectively hedged against. FDIC insurance does not eliminate this liquidity risk, it just takes the depositor side of it and moves that to the Government. As Mencius Moldbug points out in this excellent discussion:
our present deposit system is equivalent to one in which Y (the bank) stores its checking deposits as cash in the vault, and then borrows money from X (the Fed) to make its 30-year mortgage loans.
In other words, given the inherent instability of fractional reserve banking, de facto, the government carries all loans on its balance sheet. This is why I applaud the Paulson plan of having the US Government buy all bad mortgage debt -- it formally acknowledges reality.

Brad DeLong, when he isn't mindlessly shrieking his devoutness and piety, has some useful graphs that show this two-state equilibria in action.

The quantity of risk assets is fixed (at least in the short term -- these would be the 30 year mortgages) but their price can get locked into a high or low equilibrium state. The high state corresponds to maturity transformation working, and the low state corresponds to a bank run. Remember -- bank runs can happen for NO REASON. So, while Brad gets the two-state equilibrium right, he gets the causality wrong:
But there is another mode of operation: if financial intermediaries are poorly-capitalized they themselves will have great problems borrowing--savers will fear the moral hazard problems that arise when those who manage their money don't themselves have a large stake in the game, and a financial intermediary without a large equity cushion leads savers to ask the American question "if you're so smart, why aren't you rich?" and shy away. So if financial intermediaries are poorly-capitalized, supply and demand looks very different [and you switch to the bank run state]:
Here, Brad says that a lack of solvency triggers the bank run, but we know that the bank run can start spontaneously -- ie. for no reason at all. So, bank run = maturity transformation stopping = "liquidity dries up" = lower price of long term risk assets because risk assets have one price when maturity transformation works, and another when it does not. In other words, embedded in the price of a long term risk asset, is the value of maturity transformation. The ability of maturity transformation makes long term risk assets seem great and at the same time permanently destabilize and undermine the system, paving the way for its collapse. If this makes you think of cocaine, you are not the only one.

Think of this another way -- how much would a 30 year CD need to pay to make you happy to sign away $ for three decades? Would 4% cover it? If maturity transformation turned off, and 30 year bonds really needed to be held for 30 years, they would need to be sold for pennies on the dollar. Maturity transformation creates the feedback loop between the price of risk assets and the willingness of short term depositors to lend, so the liquidity of a financial institution and its solvency are one and the same.

Steve Waldman, who I think the world of, also gets this relationship wrong, I think.
There is no question that we are going to spend a lot of public money to address the current crisis. We have already put a very extraordinary amount at risk. The question we should be asking is not whether or how much, but to whom and for what. The financial crisis we are facing is a symptom of a much larger economic and social crisis. Wall Street is not the source of the pain. On the contrary, the financial sector has been put this decade primarily in the service of hiding, literally of papering over, unsustainable trends in the current account, income distribution, human and physical capital deterioration, and the sectoral composition of the American economy. The conventional wisdom is that this is a financial crisis, and that so far "Main Street" has been largely insulated from the catastrophe. That is rubbish. The cancer is on Main Street, and the tumor has been growing there for years. Wall Street provided drugs to hide the pain and keep us going, palliative but not curative. What is happening now is those drugs are wearing off. The American economy is fundamentally unsound, and has been for some time. We would have noticed sooner, were it not for financial methamphetamine conjured by mad scientists in lower Manhattan from a whirlwind of foreign central bank money.
I completely agree that the American economy is unsound, but I believe the root causes are strictly monetary. American's are good at business. But we are lousy at controlling the money supply. And this is the difference between asset bubbles and credit bubbles. Asset bubbles debauch the asset class when they ultimately pop, while credit bubbles debauch the currency -- and therefore the economy as a whole. Greenspan's actions to treat the internet bust in 2000 as if it was a credit bubble is going down in history as one of the worst decisions by a central banker, ever. His conversion from Maestro to Goat is complete.

To wrap up an overly long post, it is good that the Government is recognizing its role as lender for risk assets, and simply taking all the loans onto its balance sheet effectively nationalizing the mortgage market, and perhaps all of the financial system. However, their actions will be focused on propping up what needs to be propped up to get us back into the maturity transformation game. Regulations around mortgages, investment banks, CDSs etc. are meaningless because the inherent instability in the system will simply find a new avenue to express itself, resulting in a larger liquidity implosion in the future. The world will not get off the dollar until China decides to get off the dollar, and the PBoC, as a matter of policy, does not seem interested in doing that this time.


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