Immediate Focus Of Central Banks Is Preventing A Global Liquidity Crisis

Coordinated action by central banks creating massive liquidity in financial markets worldwide

Central banks around the world are engaged in a coordinated effort to prevent a liquidity crisis in the financial markets and stave off a worldwide depression. A liquidity crisis in the markets, which is a shortage of actual money, is always caused by a harshly negative economic event that comes out of nowhere. The COVID-19 pandemic we are living through is obviously such an event. A liquidity crisis causes a significant and immediate decline in business activity. But it’s important to remember the crisis in liquidity is the result of an event and not the event itself. Consumers and businesses stop spending, manufacturers cut output, and cash flow drops.

Before the pandemic, just like the years before the Great Recession that began in 2008, the business had been growing and the economy had been running smoothly. What keeps the economy running smoothly are banks around the country and world lending money short term (a year or less) to creditworthy borrowers so they can pay their everyday expenses. Companies require this because proceeds from product sales rarely match-up to the dates when money is needed for payroll, for example.

Pandemic out of the blue slammed the economy

The COVID-19 pandemic came out of nowhere, slammed the economy with the destructive force of Category 5 hurricane on steroids, and caused immense damage to both the U.S. and the global economy.  If you sustain a hit to your economy like the pandemic combined with tight or even standard money supply, many businesses and individuals suddenly have negative cash flow, and they begin to withdraw money from their banks. In plain terms, the immediate demand for money exceeds the supply of cash available.

Banks have to meet capital requirements mandated by the government. A massive run-off in deposits can push banks over the edge into massive and complex bankruptcies as happened in 2008. [1] If banks suddenly fear a threat to their capital base, they immediately begin to hoard cash to maintain their capital while simultaneously trying to sell the long-term instruments they hold to build their cash position. Everyone starts selling but almost no one is buying. Markets lock-up; investors start to dump stocks and bonds issued by banks onto the market with instructions to sell at any price. You can see how this can easily trigger a global financial disaster.

A short-term liquidity crisis can spiral down fast

One of the quickest ways banks can retain cash is to immediately curtail the size of the lines of credit they had extended to their corporate clients. Creditworthy companies that urgently need short-term money because of a loss of business suddenly cannot get additional credit from their bank. This, in turn, causes corporations to both to lay people off and withdraw deposits to meet their short-term expenses. Those individuals suddenly unemployed start to spend down their cash kept at a bank. At the very moment banks need it, cash begins to drain away from the banking system. It is akin to a simultaneous run on the largest and most important global banks.

Central banks now flooding the financial system with cash

The moment the U.S. Fed and other central banks saw the signs of a liquidity crisis in the making, they immediately began to increase the money supply (loose monetary policy vs tight monetary policy) through quantitative easing. This is the phrase economists use for printing money. Increasing the money supply also has the effect of lowering interest rates.  

To keep interest rates near zero and to prevent a liquidity crisis, the U.S. Federal Reserve and central banks around the globe will continue their policy of unlimited quantitative easing for as long as it is needed to repair the damage done to the economy by the COVID-19 virus. The takeaway for you as a Financial Advisor? Low-rates and easy money are here to stay.

Resource:

[1] Too Big to Fail recounts the fascinating and jolting financial crisis which precipitated the economic collapse beginning in 2008. It is both a fascinating book and a movie made from the book. Both show the step by step disaster which begins to unfold with firms thought to be financially strong contacting the Treasury almost every day to sheepishly report their bookkeeping might have been a little off and without a massive cash infusion, they will go under in a few days.

Copyright© 2020 Cannon Financial Institute - All Rights Reserved

Subscribe to Cannon Insights at http://www.cannonfinancial.com/newsletter/subscribe.

Contributing Writer: Subject Matter Expert Charles McCain