Liquidity

There is a disagreement as to just what caused the Great Depression, but the general problem once it started was one of liquidity: there was not enough money available. This led to price deflation, which led to people saving their money rather than spending it, which led to people not buying things, which led to workers being laid off, which led to even more people buying even less, which led to a slow moving positive feedback loop driving down the economy. The New Deal broke the feedback loop by pumping money into the economy and by insuring bank deposits, but the economy did not really get going again until World War II greatly increased employment by opening armament factories and putting millions of people into the armed forces.

It could never happen again, because the government would never permit liquidity to get too low. Or, would it? As we all know, the years after 2001 saw a credit boom, visible primarily in the spread of mortgages but also in the gigantic market for credit default swaps. Viewed at a snapshot in time, extending credit can be seen as creating new money. When the total indebtedness of the economy rises, there is in practice more money floating around—although of course all of the new money is supposed to get resolved into cash at some point.

The bills on a lot of the credit are now coming due. Some homeowners are defaulting, which pushes the debt back to the holders of the mortgage. Likewise for banks going bankrupt. Large financial organizations are writing off debt, which means that they need more cash to keep their balance sheets stable.

Although on paper this does not affect liquidity, I would argue that the resulting drop of the supply of credit means that at the present moment liquidity is going down. With the price of housing and oil dropping, it is possible that we are heading for a period of price deflation. The government is working to counteract that by pumping money into the economy via the banks, but the banks are using the money to prop up their balance sheets rather than extending new loans. The amount of money the government has put in is a pittance compared to the size of the credit default swap market (though it is also possible that the credit default swap market will largely cancel out—we don’t really know).

So it seems to me that it is possible that we are heading for a positive feedback loop like the one which made the Depression so bad. Fortunately today’s government is much more reactive than Hoover’s, and if Obama wins it is likely that he will immediately reprise many of the ideas of the New Deal, notably by increasing spending on infrastructure. So it will most likely all just fizzle out. We’ll see.

4 Comments »

  1. mseaborn said,

    November 3, 2008 @ 10:56 am

    “Although of course all of the new money is supposed to get resolved into cash at some point” – A lot of it doesn’t. If you think about it, these days you can get by almost without ever using cash if you use a credit or debit card to pay for everything.

    Economists refer to these different kinds of money as M0, M1, M2 etc., with M0 being cash and M1 being deposit money. There are some interesting graphs on http://en.wikipedia.org/wiki/Money_supply showing how the higher Ms are growing.

  2. Ian Lance Taylor said,

    November 5, 2008 @ 5:40 pm

    Thanks for the comment.

  3. fche said,

    November 25, 2008 @ 1:06 pm

    if Obama wins it is likely that he will immediately reprise many of the ideas of the New Deal, notably by increasing spending on infrastructure. So it will most likely all just fizzle out

    On the other hand, there are many who argue that elements of the New Deal actually made the depression worse and longer than necessary. So I hope Obama’s people read up and avoid the excesses of Roosevelt et al.

  4. Ian Lance Taylor said,

    November 28, 2008 @ 11:19 am

    FDR tried all kinds of things in the New Deal. Some helped, some didn’t. Presumably we can learn from the experience. I think the most successful ones were specifically increasing spending on infrastructure via the WPA and friends.

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