MarketWatch: A liquidity trap reminiscent of the 1930s

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The liquidity trap
Commentary: Financial engineering seems worse than the alternative
By Jim Anderson


SAN FRANCISCO (MarketWatch) -- This year one of the best performing asset classes is cash.

People used to boast about hot stocks they owned. Now they crow about how much of their money is in cash. Those holding cash have been richly rewarded with no losses and opportunities to buy assets (condos and equities) at huge discounts.

As prices continue to decline, those that moved too quickly to buy at the bottom are seen as fools. Consider the massive losses of the sovereign wealth funds, Bank of America and Countrywide, and even Warren Buffett's latest foray into General Electric and Goldman Sachs. Investors, convinced that prices will continue to decline, sit with their liquid resources on the sidelines. As that investment demand takes a holiday, prices will decline further.

This phenomenon is well understood. In the 1930s, it was called the liquidity trap. People took their money out of the bank and literally buried in the backyard or stuck it under a mattress. When that happened, the money supply contracted another notch and the lack of transactions cut into the velocity of money.

As the supply of money and bank reserves dried up, credit availability declined and asset prices fell yet again. Today, because of FDIC insurance it is not the households that lack trust in the banking system but, rather, the bankers themselves.

Even with fed funds at 1%, the lending rate among banks (LIBOR) until recently was stuck above 4%. Even now with four week LIBOR down to 1.21% it is 100 basis points above Treasurys. .......(more)

The complete piece is at: http://www.marketwatch.com/news/story/The-liquidity-tra...

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1. The banks need to open their books.

It's that simple: the Commerce Dept need to establish a tough, standardized auditing system and every bank in the country should be subjected to it. It's the only way to reassure lenders that they're not throwing money down a hole. When I apply for a loan, my personal financial information going back ten years or so is right there for the loan officer to examine: assets, debts, income, credit history, the whole deal. The banks have been lending to one another solely on reputation: that no longer works.