Thursday, 26 November 2009

One possible cause of bubbles is excessive monetary liquidity in the financial system


One possible cause of bubbles is excessive monetary liquidity in the financial system, inducing lax or inappropriate lending standards by the banks, which asset markets are then caused to be vulnerable to volatile hyperinflation caused by short-term, leveraged speculation. For example, Axel A. Weber, the president of the Deutsche Bundesbank, has argued that "The past has shown that an overly generous provision of liquidity in global financial markets in connection with a very low level of interest rates promotes the formation of asset-price bubbles."  According to the explanation, excessive monetary liquidity (easy credit, large disposable incomes) potentially occurs while fractional reserve banks are implementing expansionary monetary policy (i.e. lowering of interest rates and flushing the financial system with money supply). When interest rates are going down, investors tend to avoid putting their capital into savings accounts. Instead, investors tend to leverage their capital by borrowing from banks and invest the leveraged capital in financial assets such as equities and real estate.

Simply put, economic bubbles often occur when too much money is chasing too few assets, causing both good assets and bad assets to appreciate excessively beyond their fundamentals to an unsustainable level. Once the bubble bursts the central bank will be forced to reverse its monetary accommodation policy and soak up the liquidity in the financial system or risk a collapse of its currency. The removal of monetary accommodation policy is commonly known as a contractionary monetary policy. When the central bank raises interest rates, investors tend to become risk averse and thus avoid leveraged capital because the costs of borrowing may become too expensive.

Advocates of this perspective refer to (such) bubbles as "credit bubbles," and look at such measures of financial leverage as debt to GDP ratios to identify bubbles.

No comments: