ETM Analytics has created an index that shows distinct peaks and troughs of dollar liquidity, henceforth called dollar liquidity summers and winters. Summers are periods of abundant liquidity when banks rapidly create new loans or when central banks inject large sums of money into the financial system. Summers are associated with greater investor confidence, higher risk-taking and rising asset prices. But they can also foster excessive leverage (investing with borrowed money), irrational exuberance and poor capital investment. Moreover, they can inflate bubbles, which can create economic and financial instability.
During liquidity winters, on the other hand, banks' lending standards tighten up, and central banks stop printing money or even withdraw money from the system. Winters are associated with a much lower appetite for investment risk, deflation in bubble sectors, financial crises and recessions. But winters can also correct excesses, reallocate capital more efficiently, repair balance sheets, and make goods and services more affordable.
The U.S. Federal Reserve created a liquidity summer when it implemented a policy of quantitative easing in 2008-2014. When it tapered that policy, the liquidity winter in which we now find ourselves emerged. With the winter came collapsing commodity prices, cracking currency pegs, fearful corporate bond markets, crashing Chinese stocks and volatility on Wall Street.
A Workable Compromise?
So why not just keep the money flowing and enjoy an endless summer? It's an idea that has, in fact, guided many of the Fed's decisions for the past 30 years. Every time a liquidity winter sprung up naturally, the Fed melted it away by fabricating another summer. But if winters and their financial discontents are necessary corrective processes, then an endless summer is not as pleasant as it may at first sound. Perpetuating bad investments and price distortions can come at a high structural cost — a cost that does not even account for currency fragility and the inevitable loss of monetary credibility.
Such was the case in the 1990s. A liquidity summer gave rise to a gratuitous use of leverage. The build-up of global leverage, in turn, led to the contagion of the Asian crisis, the Russian default, the failure of Long-Term Capital Management, the bust of the dot-com bubble and the collapse in U.S. household net worth, which had been inflated far above its long-term historical average. The market eventually restored asset affordability and corrected the imbalance between incomes and asset prices.
The problem, however, is that when net worth rises because of leverage-induced asset inflation, a fall in asset prices impairs the balance sheets of heavily indebted households. Asset deflation sends a pulse of credit contraction through the economy. In a panic, the Fed opened the monetary taps, sparking a new summer and enlarging commodity, property and stock market bubbles by 2007. It also raised U.S. household net worth to levels even higher than those of the 1990s.
By 2006, the Fed normalized its monetary policy to allay concerns of financial instability. But by then it was already too late: When the next winter set in, net worth fell again. Asset deflation restored affordability, but affordability came at the expense of net worth and the health of balance sheets.
The Fed behaved even more aggressively in 2008 than it did in the early 2000s. It lowered interest rates to zero, printed money hand over fist to bail out U.S. banks, monetized the national debt and restored balance sheets. But again, the health of balance sheets was restored at the expense of asset affordability.
The Fed still has not figured out how to restore affordability and normalize monetary conditions at the same time. Meaningful monetary normalization could send paper wealth crashing back down to Earth. Household net worth has proved extremely precarious when it exceeds 600 percent of disposable income (as it currently does). To maintain some degree of asset affordability at these levels, the Fed needs banks with lower lending standards to lend at extremely low rates. Monetary policy normalization does not comport with that strategy, hence the Fed's aversion to raising interest rates.
Washington may believe that this is a workable compromise for now, but the constant reflation of asset bubbles is systemically exhausting. Since 2000, it has taken a 220 percent ballooning in federal debt and a 550 percent explosion in the Fed's balance sheet to maintain the reflation strategy. Along the way, desperate policymakers had to redesign the monetary and banking systems, and wealth and income inequality has increased, favoring asset owners at the expense of those yet to acquire assets. In return, per capita real GDP has grown by only 1 percent per year, and median real household income has fallen.
The Frostbite Spreads
There are almost no good options left for the Fed. Quantitative easing is not the answer. Winters are cyclically painful, but endless summers erode structural stability. Monetary authorities do not want assets to be less affordable, but they also do not want to deflate the price of assets — nor do they want to impair balance sheets. Supporting asset prices through quantitative easing-induced asset buying does not reconcile the differences between affordability and balance sheet repair. If anything, it creates larger, more volatile bubbles. Enacting an additional round of quantitative easing, moreover, could endorse the opinions of some that the Fed is trapped in a cycle of its own making.
Another approach is to try to raise household incomes faster than asset prices, something that would require injecting liquidity into households more directly. This idea has given credence to the concept of "helicopter money," whereby governments raise revenue by selling bonds directly to central banks. But if additional quantitative easing validates the belief that the Fed cannot escape the cycle it finds itself in, helicopter money would validate it even more so. Though it would increase incomes, it could also erode financial and fiscal confidence and engender risks of inflation. If that happened, it could incite a flight to hard assets, such as gold and real estate, from financial assets, such as the government bond market — arguably the biggest financial bubble in history. The financial capitals of the world understand the danger of holding a pin too close to this bubble.
And yet Washington has a potential, albeit temporary, solution: commercial banks, which could shoulder some of the monetary heavy lifting on the Fed's behalf. Commercial banks, because they are licensed to create money, can write new loans to the federal government. Doing so would expand dollar liquidity, keep the spotlight off the Fed and enable the Treasury Department to ramp up fiscal stimulus during an election year.
There are some indications that this effort is already underway. Bank lending is buoyant, and deficit expansion is rising. Low bond yields, tight constraints on the Fed's behavior and the as yet undecided presidential election may all point toward greater fiscal expansionism.
Still, it is unclear just how effective this policy would be. Bank-funded fiscal expansion could warm the winter chill, but it may not be enough to change the dollar liquidity season entirely.
Either way, it is hard to ignore the possibility that the only viable way out of the Fed's dilemma is to allow, or even facilitate, a necessary transition from one period — in which asset price growth outstrips income growth — to an opposite period. The tension between the market imperative of asset affordability and the political imperative of balance sheet protection will be worked out, one way or another, and the process by which that happens will almost certainly be painful. Liquidity winters such as the one in which we find ourselves are associated with much smaller investor appetite for risk, deflation in bubble sectors, financial crises and recessions. It would be a mistake to think that commodity bubbles and emerging market bubbles will be the only casualties of the current cycle. Once the frostbite of winter spreads, it is notoriously difficult to stop.