When the savings and liquidity gluts end

Buried within an otherwise fascinating tour of the last few decades of financial history, Martin Wolf of the Financial Times raises a particularly insightful question that was surely lost on all but a few of his readers.

In The new capitalism, come these gems:

Two further long-term developments help explain what has happened. The first is the revolution in financial economics, notably the discovery of options pricing by Myron Scholes and Fischer Black in the early 1970s, which provided the technical underpinning of today's vast options markets. The second is the success of central banks in creating a stable monetary background for the world economy and so also for the global financial system. "Fiat" (or government-created) money has now worked well for a quarter of a century, providing the monetary stability on which complex financial systems have always depended.

Yet there is also a shorter-term explanation for the explosive recent growth in finance: today's global savings and liquidity gluts. Low interest rates and the accumulation of liquid assets, not least by central banks around the world, has fueled financial engineering and leverage. How much of the recent growth of the financial system is due to these relatively short-term developments and how much to longer-term structural features will be known only when the easy conditions end, as they will.

Left unstated here is the obvious relationship between "fiat" money and the two "gluts" that are integral parts of today's financial world - the "savings glut" and the "liquidity glut".

You don't normally get too many "gluts" (or the resulting asset bubbles) when the creation of money and credit are subject to some kind of restraint. That is, the kind of restraint that you see when money and credit are not simply created by government "fiat" or Wall Street "fiat" (e.g., securitized debt, etc.) and are then subject to some reasonable bank reserve requirement.

It is more than interesting that Mr. Wolf can be so sure of the fate of the gluts - "when the easy conditions end, as they will" - yet apparently unaware or uninterested in their causes.