Let Global Liquidity Be Your Guide for Next Crisis

F John Mathis, Jarl Kallberg and Frank Tuzzolino

By F. John Mathis, Jarl Kallberg and Frank Tuzzolino, Thunderbird professors

Financial shocks have become an increasingly pervasive feature of the global economic landscape. Perhaps the most devastating aspect of these events is something economists call “contagion.” Contagion occurs when an economic shock in one location reverberates in other countries, markets and sectors that have little apparent exposure to the initiating factors. The current global financial crisis and others, such as the bursting of the technology bubble in 2000, emphasize these linkages. But what starts this process is excessive liquidity.

Growing global threats

Though globalization creates incredible opportunity for sustainable prosperity worldwide, it also increases the exposure of countries, organizations and individuals to external risks that can trigger instability. Between 1975 and 1997, the International Monetary Fund reported a whopping number of financial crises. These included 158 currency crises and 54 banking crises. Studies of financial instability have identified many triggers. However, one that data from the IMF has suggested as a primary driver is global liquidity. Crises are preceded by a noticeable change in global liquidity, which refers to the supply of convertible currencies created by major industrial countries and the flow of this capital across borders.

Beware of overinvestment

These global flows can lead to highly levered overinvestment. As capital flows into a given sector that has experienced historically high rates of return, the seemingly compelling investment opportunities inevitably are gobbled up, leaving more marginal investments. But with surplus liquidity, low interest rates and narrow credit spreads even these investment can be rationalized. The most recent saga in U.S. residential housing attests to such a transformation, hallmarked by the greater proportion of speculative positions borne by market participants, and the attendant decline in credit quality. Investment in new residential housing in the United States grew from $364 million in 1993 to nearly $1 trillion in March 2008.

This surge in investment was fed by the rapid increase in housing prices throughout the United States. Median home prices rose from $119,000 in 1993 to their peak of $253,000 in August 2007. When the inevitable decline in prices ensued, the dubious underwriting policies of mortgage lenders were exposed.

Such elements of the mortgage “toxic waste” problem included no down payment, no income or asset verification, negative amortization, interest-only loans and reckless adjustable-rate mortgages. Accordingly, the subprime market collapsed, wreaking havoc throughout the entire U.S. and, eventually, the world economy. Managers seeking to navigate such disasters in the future should use a measure of excessive liquidly resulting in overinvestment as a guide. In other words, they should pay attention to changes in global liquidity relative to changes in world gross domestic product.

During the period 1999 to 2007, the average annual growth in GDP was relatively stable at 4.4 percent. The average annual growth in the volume of world trade in goods and services was 6.8 percent. In contrast, the annual growth in global liquidity averaged almost 24 percent per year over the period 1995 to 2006. Global liquidity was relatively stable at 6 percent of world GDP until a couple of years immediately preceding the technology bubble in 2000 and the mortgage crisis in 2007, when it rose to 12 percent and 18 percent, respectively. Even though annual average global liquidity growth significantly exceeded average annual growth in real GDP and trade, there was no significant rise in inflation. However, many commodity prices, particularly oil and metals, experienced sharp increases.

The global liquidity link

As liquidity increases and interest rates and credit spreads fall, managers are encouraged — even compelled — to invest this cheap capital. The resulting increase in the pace of economic activity suggests that future cash flows on investment will support these new ventures, seemingly good news. However, the additional risks accompanying this heightened economic activity subvert the process in the longer run. At least three mechanisms govern this process.

First, increased liquidity leads to a search for investment opportunities that grow more risky and less rewarding as the supply of bargains dwindles. Secondly, as investors bid against each other, they drive up asset prices to inflated levels, and the returns available to higher risk assets diminish and the risk premium narrows. These two factors drive liquidity into increasingly risky assets. Thus begins an asset-price bubble that feeds on itself, fueled by the continuing growth in liquidity relative to real GDP growth. This momentum is broken only when the growth in liquidity subsides or when asset prices are no longer credible, thereby triggering a crisis.

The timing of the collapse is related to the rate of increase in liquidity and asset prices, and the general belief that such buoyancy will continue. The third factor that comes into play is moral hazard. Companies and investors, believing that governments will bail them out or that they are too big to fail, exercise less diligence. The stage is thus set for a liquidity spiral, to which the global bailouts of investment banks, commercial banks and insurance companies will attest.

F. John Mathis, Ph.D., is director of the Thunderbird Global Financial Services Center and Thunderbird professor of global finance. Jarl Kallberg, Ph.D., is a Thunderbird professor of global finance. He is an associate editor of the Journal of Real Estate Economics and is on the editorial board of the Journal of Corporate Treasury Management. Frank Tuzzolino, Ph.D., is a Thunderbird associate professor of finance. He has won nine outstanding faculty teaching awards at Thunderbird and is an Arizona State University fellow.