In the summer of 2007, a contagious liquidity meltdown hit the world markets. Sparked by the sub-prime mortgage fiasco in the USA, financial panic and tumbling asset values did not only destabilise the American financial system, but have also shaken the European and Asian markets. Over the course of the following eighteen months, a contagious financial crisis has been transformed into a recession that increasingly becomes world-wide. Some analysts evaluate the losses related to the global credit crunch at around $2 trillion (Roubini 2008). The casualty count from the global credit crunch has included high-profile firms like Bear Sterns, Lehman Brothers and AIG insurance firms in the US, Northern Rock and Lloyds (HBOS) in the UK, several European banks, companies in the real economy, the entire banking system of Iceland and crucially, growing numbers of people who have lost or are on the brink of losing their homes and jobs.
The crisis prompted unprecedented emergency measures by the public authorities in the USA, Japan, the EU, and later Canada, Australia, the UK and emerging markets. The sheer scale of monetary injections by the central banks over the course of the crisis is unprecedented in economic history, as are the levels of interest rates that currently are at their historical lows. As the financial meltdown approaches its second anniversary and as newly revealed bank losses and defaults in the non-financial sectors prompt fears a global depression, sceptics warn that more strains are hidden in complex pyramids of credit around the world. In turn, the insiders of the securitisation market--for many years the largest source of funding for mortgages and consumer credit--have come to believe that the industry may not recover its levels of trade until 2011-2012 (van Duyn 2009).
Financial crises are always costly for those involved; they tend to expose errors of both policy-making and financial practice. In this, the global credit crunch is not a unique event. It has unmasked the American sub-prime mortgage industry as a scam; it has revealed that many high-ranking financial institutions have been entangled in complex chains of dubious debts and even Ponzi schemes; (2) and it has also shown that the public authorities have lost track of the real effects of financial deregulation. At the same time, while investor herding, exuberance, speculation and the gap between regulatory oversight and the spiral of private financial innovation have been present in most outbreaks of financial volatility during the past twenty years, the global credit crunch has brought up two perplexing issues concerning the nature of today's finance in particular.
The first puzzle is the apparent shock of the event. In the summer of 2007, falling market values seemed to have caught many market players and observers by surprise. For instance, a lawyer for Mr Cioffi, one of the managers of the crippled Bear Sterns fund has argued: "the credit crisis took everyone by surprise, including the Fed and the Treasury. Dozens of the largest financial institutions in the world have lost over $300 billion to date on the same investments." (3) While treating the crisis as a 'surprise' and shock may well be a trick of a skilled lawyer defending two financiers against the nine-count indictment with conspiracy, securities and wire fraud, treating the crisis as a 'surprise' does not make much sense outside the courtroom. Indeed, the risks unleashed and accentuated by the securitisation process, as well as the fragility of the US mortgage market and the economy as a whole had been noted repeatedly by many commentators long before the turmoil began in the summer of 2007. For instance, as William White of the BIS observed, "the opacity and complexity of the financial system today shrouds in secrecy who finally bears the risks, and increases the likelihood of operational problems. More broadly, the reliance of banks in many countries on revenues from dealing with the household sector, already heavily indebted, could in the future prove a source of financial vulnerability ... these exposures might also have increased over time in response to successive episodes of monetary easing and associated credit expansion" (White 2006b: 5-6).
The second puzzle of the global credit meltdown relates to its diagnosis. Most analysts concur that at the epicentre of the meltdown has been the fall of the subprime mortgage industry in the US and a subsequent systemic liquidity and credit crunch. Such a consensus is quite baffling, since only a few months prior to the implosion of August 2007, financial commentators left and right cited 'excess global liquidity' and even 'liquidity glut' washing across global markets (Bernanke 2005, 2008; Guha 2007; Bini Smaghi 2007). In November 2006 for instance, Raghuram Rajan of the IMF noted that:
"The mismatch between unabated global desired savings and lower realized investment, between the amounts available for finance and the flow of hard assets to absorb it, has led to a liquidity glut which has pushed long term real interest rates the world over lower."
Analysing the forces behind the global glut of excess liquidity, he suggested that it is chiefly driven by "foreign central bank purchases of U.S. assets [that] reflect the savings investment imbalance in their own countries" (Rajan 2006: 5-7).4 In its publications at the time, the IMF warned against the inflation-related dangers of excess global liquidity. So how could this global glut of 'excess liquidity' possibly evaporate overnight?
In this article I argue that the key puzzle of the 2007-200? crisis, and the reason so many warnings about the impeding collapse had been ignored, stems from an important, yet overlooked, role of liquidity and its dynamics in the contemporary financial system. More specifically, I argue that it is the phenomenon of liquidity illusion that had precipitated the continuing financial turmoil and subsequent recession.
Originally identified by Keynes, liquidity illusions have been behind many financial euphorias and bubbles throughout history, but it is during the past two decades that illusions of liquidity have become a central element of financial crises around the world. The BIS Committee on the Global Financial System has defined liquidity illusion as a situation in which markets under-price liquidity and financial institutions underestimate liquidity risks (CGFS 2001: 2). Essentially, the illusion of liquidity is a false sense of optimism a financial actor (be that company, fund manager or a government) has over the safety and resilience of her portfolio, and/or market as a whole. In periods of economic upturn and optimism, investors eagerly expand their credit lines, often underestimating risks in the belief that their investment structures are safe and liquid. Yet when across the board, financial institutions share optimistic expectations and stretch their portfolios too far, the system as a whole becomes progressively illiquid and therefore, fragile (Nesvetailova 2007). When distress hits the market, credit lines that had been advanced only a short while ago cannot be closed without losses; contagion--often involving asset deflation--spreads through the market, leading up to insolvencies and a systemic breakdown.
As the term itself suggests, the problem of liquidity illusion is difficult to diagnose accurately and in time. In the words of Andrew Crockett, liquidity itself is an elusive concept; "it is easier to recognise it than define" (2008: 14). The notion of liquidity centres on the dynamic interplay between the processes of financial deregulation and innovation and subjective factors, such as confidence and expectations, which are not easily modelled or measured in a dynamic context. Still, it is notable that in the wake of the series of crises of the past decade, some strands of research in finance have identified the complex issue of liquidity as a key element of systemic risk in finance generally (Bies 2002; Bird and Milne 1999; Bisigano 1999; Chang and Velasco 1998, 1999; Goldfrain and Valdes 1997; Mishkin 1999; Pettis 2001, 2003; Persaud 2002; Alexander et al. 2006). The discussion however, has been mostly confined to academic circles, and up until very recently (5) no policy forum has addressed the problem comprehensively.
There can be identified at least two reasons behind this. First, as noted above, in the decades following the end of the Bretton Woods regime of financial regulation, liquidity management--once a priority for any central bank--has become a marginal concern for monetary and financial authorities: deregulated and self-governed financial systems were assumed to fulfil liquidity-balancing functions by themselves (Nesvetailova 2008). Second, the apparent gap between theoretical inquiry and economic policy has arisen because the nature and behaviour of liquidity today are incredibly complex, overlapping several layers of the activity in the financial markets and macroeconomy as a whole. Understanding these issues in the context of deregulated and privatised credit system requires a qualitatively new approach to the financial system and its risk channels. While the ongoing financial meltdown has initiated some long-needed inquires into these issues (Borio 2008), the crisis does not seem to have shaken the basic paradigms of the field of academic finance and economics (e.g. Tatom 2008; Ondo-Ndang and Scialom 2008).
In what follows, I identify and analyse some systemic implications of liquidity illusion at three interdependent levels: macroeconomic; market-centred and international. Although at their core, liquidity illusions tend to originate in the progressive underestimation of risks that parallels the process of financial innovation and credit expansion, in various contexts the illusions of liquidity manifest themselves in a particular manner. In the context of a national economic system (the...