TheTradingReport

Felix Salmon has a very smart post up today about liquidity and its role in creating bubbles. He quotes from an interview with Roy Smith a former Goldman banker:

There is now about $140 trillion in market capitalization in the word’s financial markets looking for investments. That money can now move around very easily. But even if a relatively small portion of that money goes after something — say, mortgages — it can quickly cause a bubble and a crisis. So all this good work we have done in the past few years to make our capital markets more efficient and open has also made them very hazardous, and we haven’t done anything yet to address that problem.

Here’s Smith’s verdict on the history of Wall Street:

The net result has been a positive for users of capital markets, which can be accessed more cheaply than ever before. But the success of the market has resulted in a vast accumulation of capital in tradable form that is now capable of wrecking whole economies. In 2000 and 2007, financial bubbles did great damage, and the monster is still out there.

Felix sees financial innovation as having been one of the drivers of this liquidity glut. I’m not sure I totally agree with him but I wouldn’t totally discount his thesis either. I tend to think that leverage and the willingness to abusively employ it probably plays a big part in magnifying the amount of available liquidity.

Nevertheless, it’s an intriguing idea and, coincidentally, Joe Weisenthal has two posts up today (here and here) that seem to validate the concept.

He points out that several of the central banks that have been recently raising rates have seen their efforts to head off domestic asset bubbles negated by str0ng inflows. Joe sums it up this way:

Let’s touch again on Morgan Stanley’s notefrom this morning about why the Reserve Bank of Australia and the Norges Bank (Norway) have prematurely stopped tightening.

Yes, part of it is fresh economic jitters in China and Europe, but what these banks realized is that they’re not getting any benefit from higher rates. Inflows aren’t slowing down, and asset values keep going up. If higher rates aren’t cooling off bubbles, then what’s the benefit?

Basically, we’re talking about Greenspan’s infamous “savings glut” all over again, except with the players reversed.

Take the two together and you paint a picture of a world in which liquidity swamps the efforts of central banks to control their domestic economies. If that indeed is what is taking place, it’s not hard to extrapolate an unfortunate end game.

National governments are not likely to continue to suffer at the hands of this pool of liquidity and if conventional monetary measures can’t control its effects then the politicians are likely to turn to less desirable alternatives. It could usher in an entire new regime of currency controls and restrictions on investments that would set back the clock to a time we probably don’t want to revisit. Revisit it they will, however, if they continue to see their economies wracked by speculation.

All of this may be transitory and, quite possibly the linkages I’ve postulated here don’t even exist. We may well move on to a period in which liquidity vastly improves the status quo. On the other hand, we might well be playing with a very dangerous fire.