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Response to Tansy_Gold (Original post)

Wed Apr 18, 2012, 11:47 PM

6. The Curious Case Of Liquidity Traps And Missing Collateral – Part 1

 

http://www.creditwritedowns.com/2012/04/the-curious-case-of-liquidity-traps-and-missing-collateral-part-1.html

...Let me begin with the following key premises for my argument and the state of the global economy and financial system post 2008/09. I will try to develop each of these statements in the posts that follows.

  • The crisis of 2008/09 has ushered in what is likely to be a period of severe stress in global sovereign fixed income markets. Sovereign debt distress and defaults are messy and costly affairs and take a long time to deal with. We have now entered a period where the next 10-20 years will see several developed economies default on their sovereign debt. Ageing populations, too low growth and insufficient future income/consumption to push forward mean that the OECD is now at an inflection point. For global financial markets this means that an unprecedented and systemic share of the global fixed income market is likely to be in distress at any given point in time over the next 10-20 years.

  • There is an acute shortage of liquid triple A rated government securities. This shortage is structural and capital deepening in emerging economies is too slow and insufficient in size to take up the slack. Pension funds, insurance companies and big real money managers are now essentially unable to construct their portfolios in such a way to match their future liabilities with a satisfactory (or perhaps even promised) yield. In addition, this leads to mispricing in remaining assets considered the last safe havens. US government bonds, UK Gilts, German Bunds, Danish Mortgage Backed Securities etc.

  • Central banks are now acting as international clearing houses for the banking system. This is mainly seen in Europe where the ECB has been forced into taking up slack for an interbank market which has essentially been broken. Lowering of collateral standards, ever higher portions of liquidity and extension of maturities of its open market operations are all signs that the ECB is now effectively not only acting as the lender of last resort, it is de-facto the vehicle through which European banks can access liquidity across all maturities. However, whether the central banks buys government bonds outright or funnels demand through the banking system amounts to the same thing.

  • The demand for credit is as much a problem as is the supply. Sifting through the references below, you will find that at least one solution to the problem is that governments must issue even more impaired debt instruments which essentially become assets backed by liabilities created by the central bank. We must understand however that the core of the problem is that there is now a structural lack of solvent sovereign and private credit demand. The argument goes that the higher demand for safe haven triple A rated assets must be met with supply by sovereign debt issuers, but the ability of governments to issue such securities is structurally impaired.

  • Central bank monetisation of government liabilities either outright or through open market operations providing liquidity to banks are not costless, even in a liquidity trap. Macroeconomic theory is currently informed by the notion that creating unlimited amount of excess bank reserves in the presence of a liquidity trap (zero velocity environment) has no malicious inflationary side effects. I think the evidence from more than three years of monetary experiment among the major central banks forces us to re-visit this conclusion.

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