Sunday, March 18, 2007

"This Is The End of The Liquidity Party"

The title is by Jim Rogers, the legendary investor/speculator (and bike world-traveler), taken from a recent interview he gave to Reuters.

Let's do some dissection:
  1. What is liquidity?
  2. Where does it come from?
  3. Where does it go?
  4. And how does its party come to an end?
1. Liquidity is created by debt. If it is easy and cheap to borrow, more and more people do so and money supply rises fast.

2. Where does liquidity (debt) come from? The chart shows debt/GDP for the four main sectors of the US economy. Households and financial corporations went on a borrowing frenzy in recent years, made possible by record-low interest rates in the US, EU, Japan and China. The explosion of credit derivatives boosted this process even further, by creating the illusion of lower credit risk.

Source: US Federal Reserve (Flow of Funds Accounts - Z.1)

3. Where does liquidity go? When the extra money chases...

(a) ...a limited supply of consumer goods ---> we get high consumer inflation.
(b) ...assets ---> we get bubbles.

Because of globalization and ultra-cheap Chinese goods, (a) was not an issue. So, we ended up with (b): asset bubbles everywhere.

4. The party ends when people can't and/or won't borrow any more.
  • People can't borrow when their incomes are no longer sufficient to service the debt.
  • People won't borrow when returns on assets become too small vs. the financing costs.
The first condition is obvious for the US just by looking at the negative personal saving ratio. Households are already spending everything they make so they can't make additional debt payments. If, nevertheless, they do somehow manage to borrow more, then it all turns into a giant Ponzi scheme of debt piled on debt, just to service even more debt. Party over, right there - and remember that 70% of US GDP is based on consumer spending.

The second condition is always more difficult to establish conclusively, because feverish, irrational capital gain expectations always overule rational rate of return calculations - until it's too late. That office party you thought would be over by 10.00 PM? It can go on until 02.00 AM if the librarian puts the lamp shade on her head and goes down to the corner store for more booze.

As far as US housing is concerned, the rent-price ratio, calculated and charted by the Philadelphia Fed (below), tells the whole rate of return story. Rents don't even come near to covering the costs of owning a house anymore.

Are there any signs that debt appetite is now slowing down? Yes. The following chart shows that debt growth for households and the financial sector finally started coming down in 2006, particularly after the second quarter. The recent sub-prime mortgage implosion must have slowed down household borrowing even further during 1Q07.

Source: US Federal Reserve (Flow of Funds Accounts - Z.1)

Is the liquidity party over like Jim Rogers claims? Yes - particularly as the cheap yen and swiss franc "carries" become more expensive. In fact, I believe the liquidity party is about to become a prolonged credit crunch: a condition where debt is both expensive and difficult to obtain and existing debt burdens become so onerous that the only way out is to continuously sell assets, driving down their price.

We will then have gone through the full cycle, from "liquidity party" to "liquidity crisis".


  1. Again, the plainest explanation!
    A couple of questions:
    How would the drive to sell off assets affect the cost of consumable goods? And, affect the value of the dollar?
    Thank you.

  2. I like plain. If I can't understand it and can't explain it to a reasonably educated adult, it can't be finance, high or low. Anyone wants complicated, try proving Fermat's theorem. Or designing a nuclear reactor...(smile).

    If we enter a deflationary period brought upon us by a credit crunch then nominal prices for consumer goods could be going down. the US makes much less of what it consumes than it used to so, as you point out, the value of the dollar is very important.

    It is not a coincidence that China and the major Middle East oil producers peg their currencies to the dollar. If that peg goes, you may indeed see virulent imported goods inflation in the US, even as assets decline in price. And they will go if the US continues on its current spend-borrow-spend cycle, resulting in dollar debasement.

    That by the way, is almost the perfect picture of a poor third world country. Expensive goods (for the locals), cheap assets.


  3. hellasious,

    One interesting point to note is that the trade deficit actually stabilized last quarter coming in at under $200 billion, its lowest level since Q3 2005.

    Much of that reduction is attributable to lower oil prices. Nevertheless, even factoring out oil, the level of imports still declined and exports increased. It seems that the decline in the dollar is starting to finally have an affect on the trade deficit.

    If we are in fact at the beginning of a credit crunch in the US and the govt and federal reserve do not take drastic measures, it seems likely the value of the dollar would increase at least on a trade weighted basis.

    Liquidation of debt and a movement toward savings by US consumers would result in reduced demand for imported goods and services. The more income that must be used to pay off debt, the less dollars are available to buy imports.

    Furthermore, the disproportionate impact on export dependent economies would make risky investment less attractive in emerging markets, thereby, resulting in a movement of capital from the periphery back to the center which is still US dollar based financial markets.

    Of course, having experienced the 1997 implosion, emerging economies are much better prepared in terms of available exchange reserves. However, it seems to meet that the rubber band is wound up much tighter this time around and might snap back more violently.

    If, however, the US govt and federal reserve undertake drastic fiscal and monetary measures then all bets are off and who knows how far the dollar might fall.

    My bet is that, particularly in light of the current domestic political situation, that the govt and federal reserve will not act quickly enough nor in the coordinated fashion necessary to stave off the debt spiral at least initially.

    However, I came to the same conclusion back in 2002 and was totally wrong.

    Once bitten twice shy.

  4. Dear anonymous,

    The trade deficit is now much more structural than it used to be, simply because the US now imports a lot more than it used to and CAN'T do otherwise - it has emasculated its manufacturing base. Whole industries have been wiped out from the face of the US. Think of China as Ohio, Indiana, Michigan... only they are an ocean transport away, now.

    In 1999 I correctly saw that the dotcom madness would crash and create a recession, necessitating a Fed cut. It did, but then 9/11 came along and pushed things down even further. We barely escaped a deflationary spiral then, by inflating and "monetizing" homes.

    Now what? What's our next trick?

    There is one ..raise earned income, (wages) by twice the rate of debt growth. Chances of such a thing happening, even though corporate earnings as % of GDP are the highest ever? Low. Look at what happened to the recent minimum wage bill...

    We are out of easy win-win fixes. From now on everything we do will have immediate win-lose characteristics:

    Higher wages=lower corporate profits.

    Higher taxes=lower consumer spending.

    We need to resume a sensible, realistic economic policy based on value added, as opposed to value borrowed and spent.


  5. hellasious,

    I agree with you that the only way out of the current dilemma is to increase salaries across the board not just for the top 1% of earners. However, like you mentioned, the chances of that happening, despite record profits, seem fairly remote.

    Ford and GM buying out more than 100,000 high paid manufacturing workers is not indicative of a rising wage environment. If anything the trend will continue in the opposite direction of reducing American wages as labor arbitrage continues to pick up steam and increasingly infiltrates the services industries.

    The idea of an "ownership society" whereby US workers become owners of global capital and benefit from the exploitation of labor arbitrage and rising US asset values financed by debt, while simultaneously reducing their own salaries, is unsustainable in the long term.

    There has not been sufficient investment in education, r&d, or renewable energies all of which are long term propositions.

    Unfortunately, changes in attitudes and values do not normally come about voluntarily and usually require severe economic and social dislocation before change can occur.

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