State of confidence, state of credit

In this month's Central Bank Focus, Paul McCulley of Pimco writes that liquidity is really a "state of mind", a point proven all too clearly during last month's Northern Rock debacle in the U.K., according to a report($) in today's Wall Street Journal.

Before continuing the unseemly pleading for lower interest rates (a task that now appears to be part of the updated job descriptions at Pimco), the subject of John Maynard Keynes and his 70 year-old discourse on the "state of confidence" (by speculators) and the "state of credit" (by lenders) is recalled in an effort to better understand what happens after a "Minsky Moment".

A "Reverse Minsky Journey" is apparently what follows these days - where borrowers and lenders alike attempt to gather their wits and once again pour their efforts into creating the next Minsky Moment.

Paul McCulley is often asked these days:

“Where did all the liquidity go? Six months ago, everybody was talking about boundless global liquidity supporting risk assets, driving risk premiums to virtually nothing, and now everybody is talking about a global liquidity crunch, driving risk premiums half the distance to the moon. Tell me, Mac, where did all the liquidity go?”

My short answer is that liquidity is not a pool of money but rather a state of mind.
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At the macro (systemic) level, liquidity is not about how many pieces of paper with pictures of dead presidents on them we have in our wallets, but rather about how much utility we derive from having them in our wallets. Or, as the cliché went in my youth in rural Virginia, liquidity is about whether the dead presidents are burning a hole in our wallets, or our pockets, as it were.

In today’s loosely regulated, globally integrated banking and capital markets, liquidity is about borrowers’ and lenders’ collective appetite for risk, a function of:

The willingness of investors to underwrite risk and uncertainty with borrowed money and the willingness of savers to lend money to investors who want to underwrite risk and uncertainty with borrowed money.

The willingness of savers to lend money and investors to underwrite risk were brought to light last month at Northern Rock where a 19th century style "run on the bank" caused millions of Britons scratch their heads.

The nation's chief regulator, FSA chairman Callum McCarthy, commented on the liquidity crisis - the rapid deteriation of the state of confidence and the state of credit.

Mr. McCarthy echoed previous comments by Mr. King that it would have been better for the central bank to provide financing covertly to prevent a crisis of confidence, though this became irrelevant after news of the bank's emergency financing became public.

Northern Rock was forced to approach the Bank of England for an emergency loan facility Sept. 19 after the collapse of credit markets left it struggling to finance its operations. Mr. Sants said that facility may not have been needed if the announcement hadn't sparked the first run on a U.K. bank in more than 140 years. The bank run was only halted after the government stepped in to guarantee deposits.

Even with more covert financing in situations such as this to bolster confidence in the future, it is likely that there are more round-trip Minsky journeys ahead of us.