Illiquidity

by danhon

Over the past couple of days I’ve been watching with (morbid?) interest what’s been happening in the credit/debt markets, hedge funds and the central banks. There’s quite a good few posts out there and tidbits of information:

(The above two Metafilter threads, while long, are highly recommended to people who don’t really know what’s going on, but would like to. I found them very useful)

At this point I start remembering that I really should read Brad DeLong‘s blog more frequently. One of Brad’s entries linked to an interesting NYT piece by Floyd Norris which had a useful backgrounder:

“Our current system of levered finance and its related structures may be critically flawed,” said William H. Gross, the chief investment officer of Pimco, a mutual fund company. “Nothing within it allows for the hedging of liquidity risk, and that is the problem at the moment.”

This problem has plagued the United States at regular intervals. The Panic of 1907 was halted only when the banker J. P. Morgan persuaded banks to stand together and halt the string of closings by lending money to threatened institutions. That led to the creation of the Federal Reserve, as Congress recoiled from the notion that the country’s financial health had relied on the wealth and wisdom of one private citizen.

Then the Depression, with a wave of bank failures, led to the establishment of deposit insurance. With that, savers became convinced that they need not worry about the health of their bank, and bank runs vanished.

But a new financial architecture emerged in the last decade — one that relied more on securities and less on banks as intermediaries. With the worth of those securities now being questioned — and no equivalent of deposit insurance — some who financed the securities want their money out, a fact that has created the 21st-century equivalent of a run on a bank.

I didn’t realise J.P. Morgan’s role in the creation of the Federal Reserve and what (in my understanding) appears also to be the creation of central banks in general.

It’s reassuring that, despite the injection of liquidity by the ECB and the Fed (the Fed’s been buying mortgage-backed securities – the new financial architecture alluded to in the Norris quote above -  and that’s unusual) – which makes it look like “the monetary base in the North Atlantic economies is 7% higher than it was yesterday–an annualized growth rate of 2100% per year“, Brad doesn’t think we’re in the running for a major financial meltdown. Yet.

Some more coverage:

More on Monday and Tuesday next week, no doubt.