Friends and colleagues often ask me “Where did all the money go? someone somewhere must have it!”. I too used to wonder – until I read this dinner speech by Benoît Cœuré, Member of the Executive Board of the ECB, which was delivered to the BIS-ECB Workshop on global liquidity a few days ago. This is well worth reading, as it is written clearly, it is a short piece (recall, it’s a dinner speech!) and it explains to a large part what happened to the global economy over the last 15 years.

The speech started off like this:

This evening there are several things I’d like to consider: I’ll outline some of the key concepts in global liquidity and also cover liquidity cycles. I’ll talk about the interaction between liquidity and risk appetite in the Asian crisis, and between liquidity and the recent financial crisis. I’ll discuss the relationship between global liquidity and the availability of safe assets, and the impact of the post-Lehman global liquidity cycle on emerging economies. Finally, I’ll explore some of the policy implications.

Obviously since risk appetite both affects and is affected by general financial conditions, one can guess M. Cœuré’s first key point about global liquidity:

In normal times, private liquidity dominates official liquidity. But private liquidity is highly pro-cyclical and highly endogenous to the conditions that prevail in the global financial system. The inherent endogeneity of private liquidity means that it can easily evaporate in times of financial stress. The pro-cyclicality is documented via the strong interaction of private liquidity and the global risk appetite of financial institutions. Indeed, the global risk appetite is one of the main determinants of the multiplier that links levels of overall liquidity to levels of official liquidity.

To illustrate his point about the self-reinforcing nature of global (private) liquidity ebbs and flows, the speaker turned to the Asian boom and bust of the late 1990’s:

Until 1997, Asia drew in almost half of the total capital inflow into developing countries. The economies of South-East Asia, in particular, maintained high interest rates that attracted foreign investors looking for high rates of return. The region received large inflows of money and saw dramatic increases in asset prices. At the same time, the region experienced high growth. This achievement was widely acclaimed as being part of the “Asian economic miracle”.

But the self-reinforcing interaction between risk appetite and liquidity came to the surface here. The surge in capital flows weakened incentives to improve transparency and corporate governance; it also fuelled leverage, pushing up asset prices further, to unsustainable levels. Those prices eventually underwent a correction, causing individuals and companies to default on their obligations.

Here is the $64 million dollar moment regarding where the money went: quite simply, in a time of panic the money evaporated away from risky assets and went in search of safe havens, such as the U.S. dollar, depressing yields on U.S. bonds of all kinds and sparking the next episode of boom-bust liquidity expansion (this time in the developed world) which ended with the collapse of Lehman Brothers and the beginning of the Great Recession:

The eventual implications of this interaction for the advanced economies were not so different from those for Asia a decade earlier. Again, one saw distorted incentives within the lender-borrower relationship, a highly leveraged economic climate, and upswings in asset prices to unsustainable levels. This resulted in the “Great Recession” and the corresponding fall in global economic activity.

The speaker concludes that even though the history of economic crises is largely dominated by the powerful tides of self-reinforcing liquidity flows, the crises themselves have their origins in more fundamental “fault lines” which are stressed past their breaking points by the sudden and massive changes of liquidity flows. Gaps in macro-prudential supervision, divergent productivity trends within the Eurozone, weak banking systems and a general undermining of market discipline during the “good times” are all to blame.

However necessary, fixing all of the above is not a sufficient therapy to prevent the recurrence of violent financial storms. The speaker states that:

…it is essential to adopt measures that can break the self-reinforcing interaction between risk appetite and liquidity in order to avoid further financial crises.

M. Cœuré then lists three avenues where more progress is needed to combat these self-reinforcing linkages:

First, capital adequacy / Basel III etc. to fix the banks. (On this matter my personal opinion is that the banks are unfixable at least over the short and medium term unless they are massively restructured, with very large asset write-downs and debt-for-equity swaps on the liability side of the banks’ balance sheet). Second, better regulation and oversight, particularly of the so-called “shadow banking system”. Third, more international coordination and activism by Central Banks.

Even if a policymaker is successful in implementing all of the above and bringing about calm and predictability back to the markets for money and credit, two criticisms remain:

– “managed stability” somehow breeds instability (channels: greed, relaxation of market discipline)

– if one convenient outcome of the sought-for “managed stability” is to save the hide of the banks and their creditors, would this be achieved at a far-too great expense for society in general or at a reasonable cost?

And so, here is at last a clue as to “where all that money went”. It is undeniable that over the last two decades a huge amount of money was created out of nothing and then malinvested, or borrowed to finance extravagant lifestyles for far too many millions of people around the world. Instead of this money being destroyed, too much of it is being kept alive and recycled via the global liquidity flows in the hunt for “the safe asset”. With every turning of the tide, the flows get bigger and bigger. And so does the damage and the devastation left behind by the massive global liquidity flows.