[A-List] Central Bank Intervention

[Henry C.K. Liu]

The time has long passed when central banks adding liquidity to the 
banking system can help a liquidity crisis in the market. When CBs add 
liquidity, it injects money into the banking system by making interest 
rate for overnight interbank banks loans lower. The theory is that banks 
will in turn make loans at lower interest rates, thus relaying the added 
liquidity to the market. But Keynes' concept of liquidity trap is that 
market preference for cash positions can outweigh interest rate 
considerations. In a financial crisis, there are not enough credit 
worthy borrowers at any interest rate levels and the number of sellers 
stay stubbornly larger than the number of buyers because sellers need to 
sell precisely because they do not have credit worthiness to borrow at 
even low interest rates. Even if CBs lower the discount rate, banks will 
still be sitting on tons of idle cash that they cannot lend. This is 
known as banks pushing on a credit string. As Keynes insightful said: 
the market can stay irrational longer than most participants can stay 
liquid. Since CBs are now mere market participants because of the 
enormous size of the debt market due to the wide-spread use of 
structured finance (derivatives), the market will stay irrational longer 
even CBs can stay liquid without driving their currencies to the ground. 
CB capacity for adding liquidity to the banking system is constrained by 
its need to protect the exchange value of its currency.

Federal Reserve flow of funds data shows outstanding home mortgages in 
Q1 2007 to be at $10.4 trillion.
Agency-and GSE-backed mortgage pools home mortgages asset amounts to 
$3.9 trillion .
Issuers of asset-backed securities home mortgages asset amounts to $1.9 
trillion.
What do you think the Fed can expect to accomplish with injecting a mere 
$50 or 100 billion, except to show its impotence?

After all, what is liquidity? Liquidity is the ability to monetized 
assets without causing prices to fall. Liquidity thus depends on more 
than just the availability of cash. It depends also on the availability 
of demand for assets, i.e. willing buyers. A liquidity crunch can 
develop even if there is plenty of zero-interest rate cash in buyers' 
pocket but every buyer is waiting for lower prices, causing assets to be 
illiquid, i.e. unable to monetize without lowering prices. Distressed 
assets cannot exit to cut losses at any price and bring down prices for 
even otherwise good assets. This is what causes contagion.

The effect of CBs injecting money into the banking system is the 
depreciation of money which now is fiat currency in all countries. When 
the ECB injects euros into its banking system, the euro will fall 
against other fiat currencies, including the dollar, forcing the Fed to 
also inject money into the US banking system. This can quickly turn into 
a competitive currency depreciation game. For all CBS, the option is a 
market crash or a currency crash, or it CBs are not careful, it can 
easily become a crash of both equities and currencies.

When debts are not repaid, economic value is destroyed which will be 
expressed in falling asset prices. Falling prices can be slowed down 
somewhat by the depreciation of money but only up to a point, after 
which worthless money can add to the fall of asset prices. That point is 
dangerously near at this very moment.

Henry C.k. Liu
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