The Liquidity Conundrum

by Inya Ivkovic, MA

After trillions of dollars worldwide have flooded global financial systems in an effort to jumpstart the global economy, policymakers now have become obsessed with how to clean up after themselves. In other words, the liquidity conundrum must be taken care of, unless central bankers would rather deal with inflation caused by all the excess liquidity.

Central bankers around the world have already sounded their commitment to what is now commonly referred to as “exit strategies.” Unfortunately, none have offered an actual plan on how to deliver on their commitments. The underlying fear is that all this government-sponsored spending and lending, unless managed correctly, is likely to create inflationary mayhem in the next two or three years. So, it’s no wonder investors are not willing to give central bankers either the benefit of the doubt or a “get-out-of-jail free” card if they fail, having in mind their shortsightedness to foresee the havoc that asset bubbles  wreaked last year.

In central bankers’ defense, it was the politicians who led them down the path of unprecedented spending and lending. The pressure was tremendous, making believers in massive economic stimuli even out of the most tenacious among contrarians. But who could stand idly by when the deepest global recession since WWII had swept us off our feet? And not in a good way.

So, as doubting Thomases grow in numbers, not seeing concrete and feasible plans on how to mop up excess liquidity in the global financial systems, investors are likely to make certain demands, such as, for example, higher yields on bonds to offset the acidic effect expected inflation is likely to have on prices and interest rates.

Now, apparently exit strategies are fairly straightforward — at least in theory. For starters, central bankers should start increasing key lending rates, which may already have been near zero for far too long. Additionally, any financial assets that central banks have absorbed during this crisis should be either sold off their balance sheets or allowed to expire. Also, cash auctions should be stopped and any outstanding collateral returned to bidders. And if there is still too much debt left in financial systems, governments could always issue more debt.

What’s stopping them? The tricky part of any exit strategy is its timing. As the global economy stabilizes, the properly administered disposal of excess liquidity should shrink governments’ balance sheets to the manageable size that would preempt inflation taking off significantly. But this entire recession has been anything but normal and predictable, and timing when to curb the economic stimuli and when to remove excess cash out of financial systems is anything but an exact science.

Most of the previous recessions would see economies jump back into gear relatively quickly. However, this time around, few believe that a turnaround is just around the corner. As people’s personal wealth has deteriorated, even as the global economy improves, consumers are more likely to focus on increasing their savings than going back to malls and car dealerships. Remaining financial strains will be hard to remove and relaxing our collective psyche will be even harder, which is what makes knowing when to implement the exit strategies the hardest task of all.