International Herald Tribune
Bowring: The scourge of liquidity
Wednesday, December 19, 2007

HONG KONG: The United States, Britain and the European Union seem to think they can debase their currencies without their creditors in the rest of the world - most of them in Asia - noticing.

That is the only construction that can be put on recent decisions by the U.S. Federal Reserve, the European Central Bank and the Bank of England to flood the markets with "liquidity."

The ECB is making available to institutions almost limitless amounts of cash, not at appropriate penalty rates but at subsidized ones. The Fed is auctioning low interest loans to holders of mortgage-backed securities. The president of the New York Federal Reserve, Timothy Geithner, suggests that still "additional instruments" may be needed to provide funds to banks.

"Liquidity" may sound positive enough, a substance that oils the wheels of commerce. In reality, the central bankers have been creating more paper money, to the legitimate concern of those holding the existing stock.

Money is created in the hope that volume alone can substitute for the lack of trust that exists between financial institutions, which has pushed inter-bank interest rates above those the central banks deem appropriate. Central banks are trying to thwart a central tenet of market capitalism - that the price of credit should reflect perceived risk.

The process of money printing can only make those who hold the bonds and other debt of the countries concerned look for almost any alternative, particularly a resource - be it gold, oil soybeans - that cannot be created by the stroke of a pen.

The supposed cure for the sub-prime mortgage crisis and related diseases is actually more damaging than facing up to the consequences of past mistakes. Money was already being created on a vast scale, despite an existing global abundance fueled by, among other factors, U.S. trade deficits.

Global foreign exchange reserves (the currencies in which other country's hold their official reserves - mostly dollars, euros, yen and pounds) have been rising at a 25 percent annual rate. Now yet more money is being flooded into the market, despite the fact there is already an abundance as shown by real (inflation adjusted) interest rates, which are very low by historical standards.

The ECB is printing more money at a time when inflation is running at over 3 percent, far above the level that is supposed to be acceptable. Year on year consumer prices in the United States are up 4.3 percent - they would be much higher if European calculation methods were used - and show little sign of abating.

By that measure, the Federal Funds rate should be more like 6.5 percent than 4.25 percent. Interest rates are far too low either to squeeze out inflation or secure the rise in savings, which the United States needs if it is to cease reliance on foreign capital.

Recent improvements in the current account deficit have been much trumpeted, but at over 5 percent of GDP it remains a shameful reflection of the U.S. sense of entitlement.

Almost everywhere in the developed world, very low or negative real interest rates were already defrauding the citizens who saved hard for retirement. Now floods of cheap, inflationary money created mainly to bail out financial institutions will make the future of responsible retirees even bleaker. And it will undermine the trust that foreign holders have in Western banks and institutions.

It will also undermine that critical element in capitalist societies: the need for trust. The official money flood is supposed to substitute for the lack of trust that private financial institutions currently have in their peers because of the opaque nature of the instruments they have created.

But using freshly printed money to paper over the cracks cannot restore trust. The only way to do that is for these institutions to be open about their assets and liabilities and subject them to the test of marketability.

It will be painful. Those who previously worked hardest to drive credit prices to ridiculously low levels will suffer most. Some will go bust. But the fittest will survive and trust will be restored - not merely in institutions but in the money and credit system.

As it is, the central banks are abandoning their responsibilities for maintaining the integrity of their currencies in a vain attempt to compensate for past regulatory failures. The result may slow the fall, but it will further boost inflation, and speed the decline of Western dominance of the global financial system.

The contrast with Asia 10 years ago is instructive. Foreign currency debt forced dramatic but short-lived recessions on Asian borrowers, followed by a sustained period of growth with low inflation and eventually to strong currencies backed by huge reserves.

Now the United States, Japan, Britain and the countries of the euro zone face the opposite: inadequate adjustment and minimal growth accompanied by high inflation and declining faith in the integrity of their currencies. Reserve status has become an opiate.