The fall in asset prices is causing the liquidity crisis, not the liquidity crisis the fall in asset prices - by John Ross

The following article appeared on the blog Key Trends in the World Economy

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The announcement that the US government is to follow the example of the British government, and buy shares in US banks in order to recapitalise them, brings to the fore one of the most important issues in the present financial crisis -one which has major financial and policy implications.
The international financial crisis is at present focused in two areas – asset values (share prices, house prices etc) and liquidity (drying up of interbank lending leading to a paralysis of the financial system). But the analysis of the interrelation of these two processes is vital in understanding how to tackle them.
The decisive question is whether it is the fall in asset values that is driving the liquidity crisis, or it is the liquidity crisis that is driving the fall in asset values? Different measures, with hugely different financial implications, follow from the two different answers.
The real cause of the crisis is that assets in the US are overvalued – in the end due to the overvaluation of the dollar. That is, if real market process were allowed to develop, and in the end no one will be able to stop them from operating in some form, these assets will be shown to have less value than their former and present prices.[1]
As these assets devalue down to their competitive market values this weakens, or renders insolvent, the balance sheet of institutions directly or indirectly holding them – that is they suffer loss or bankruptcy.
As these assets fall in value this necessarily produces a liquidity crisis - as financial institutions cannot lend, due to their overstretched balance sheet, nor are they willing to lend to other banks who are also greatly overstrained and may therefore not be able to repay loans. That is, the fall in asset values drives the liquidity crisis.
The present financial crisis logically started in the weakest and most overvalued part of US assets – the sub-prime mortgage market. But it is not confined to them and therefore spreads through other parts of the financial and asset system – the crash of share prices on Wall Street during the last week being the latest manifestation of this.
The policy conclusion that flows from this is that as the assets were overvalued, therefore someone will inevitably suffer loss as a result of their decline - this is unfortunately unavoidable. The only economic question is who will suffer this loss?
The aim of policy must be to ensure that this loss is concentrated as narrowly as possible on the source - that is those institutions most economically responsible for the crisis. If this is not done losses will necessarily spread through the system and those not responsible (viable firms, taxpayers etc) will suffer higher than necessary losses. In this case economic rationality coincides with morality.
This means shareholders in financial institutions which took the wrong decisions, that is who bought/created such overvalued assets, should not receive funds from those who were not responsible. If shareholders in institutions which made wrong decisions are safeguarded then others who bear no responsibility for this failure - viable companies, taxpayers, depositors etc - will suffer corresponding losses.
The government must naturally be prepared to step in to ensure the functioning of the banking system, but it should not be bailing out bank shareholders. This model was used, for example, in the rescue of Swedish banks in the 1990s and was also carried out in the nationalisation of Fannie Mae, Freddie Mac, and AIG in the US and Northern Rock and Bradford and Bingley in the UK. This will involve the state taking over these failing banks to ensure the functioning of the banking system.
Liquidity in this situation will be maintained by two steps. First, immediately, central banks must substitute for the frozen lending markets by themselves lending or using existing nationalised banks to do so – Northern Rock can be used in the UK for this purpose. Second, after nationalisation of the insolvent parts of the banking system, these banks can recommence interbank lending. This route will minimise losses for ordinary depositors, tax payers, consumers, and viable companies.
However consider the policy implications if, on the contrary, it is believed that it is the liquidity crisis which is driving the fall in asset values. In this case the first step is the same – the money markets are flooded with liquidity. But the second step is totally different and will result in losses being spread through the system to taxpayers and viable companies.
If it is believed that it is the liquidity crisis which is driving the fall in asset values then, as the liquidity crisis is overcome through injections of money, assets would rise in value. In particular bank shares will rise in value. It is, therefore, rational for taxpayers money to be put into bank shares, that is to ‘recapitalise’ the banks - indeed it is conceived this may even lead to a profit in the medium term. This is what the UK government proposed and it is now announced the US will follow this. However consider what will occur if this analysis has got the dominant direction of causation wrong – that is that it is the fall in asset prices which is driving the liquidity crisis and not vice versa.
First, despite the liquidity injection, the money put into bank shares will not halt the fall in asset values as this is not being driven by liquidity problems but by a quite other mechanism. Falls in asset values will therefore continue – that is the taxpayer will suffer big losses on the sums put into bank shares (this may be worsened by existing shareholders selling shares at values that have been temporarily artificially inflated by the capital injections). These losses will then make it much harder to indemnify deposit holders, tax payers, maintain public spending, assist viable companies etc – in other words those responsible for the crisis will haved been safeguarded at the expense of those not responsible for the crisis and losses will be spread through the system.
Second, the interbank lending market will have a strong tendency to jam again or to remain jammed – because the downward pressure on asset values means that banks will not be able or willing to start large scale lending. It is quite probable that in the end, to unjam this situation, the banks will have to be nationalised anyway but by this time large amounts of the taxpayers money that had been put in to 'recapitalise’ the banks will have been lost.
The mistake of believing that it is the liquidity crisis that is driving the fall in asset prices, rather than understanding that it is the fall in asset prices that is driving the liquidity crisis, will therefore lead to major losses for the taxpayers and viable companies and also fail to resolve the banking crisis.
To look at the real world, it is quite clear from the facts that it is in reality the fall in asset values that is driving the liquidity crisis and not vice versa. The crisis started in asset values, in sub prime mortgages. This, in turn, revealed that other assets, in the first places the shares and other holdings of US financial institutions, were themselves overvalued. It was this that then created the freezing of interbank lending and the other aspects of the liquidity crisis. In short it is the fall in asset prices that created the liquidity crisis, not vice versa.
Governments will not succeed in overcoming the present situation until they analyse correctly its dominant direction of causation and adopt the appropriate policies.

Notes

[1] This working out of market forces could theoretically take many forms. One, which did not occur, was a gradual devaluation of the dollar over a prolonged period of years. A second would be a sudden drop in the exchange rate of the dollar - that is nominal dollar prices might not fall but their real international value would be cut. A third would be that the exchange rate of the dollar remained the same but that the nominal dollar price of assets fell sharply. But in all cases the price of the dollar denominated assets will fall. Which of these variants occurs depends on other, more short term, factors. In the present phase the dominant process is the third.