Investors are preoccupied with the current liquidity crisis but seem blind to the more serious dangers of low capital productivity. Few question why real interest rates are so low? And far more accept and enjoy prevailing low financial market volatility. The roots come back to the emerging market economies. China is the problem: not US housing. China is growing fast but it has few profits. Consequently, it requires more and-more credit to sustain growth.

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Over the past few decades, the major US banks have substantially cut back their holdings of liquid assets. At their peak in the early 1950s, liquid assets comprised over 60% of banks' assets, compared to around 3% today.

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This shift has been encouraged, first, by the shift away from traditional reserve ratio control to control over capital ratios (e.g. Basel II); and second, by the more active funding by Central Bank repo activity (currently over 10% of liabilities6). See Figures 7 and 8. Figure 7. Breakdown Of US Bank Assets, 1950, 1980 And 2006 (Percent) Both trends have simultaneously increased the elasticity of credit, allowing credit to leapfrog bank deposits, and reduced the need for banks to carry large reserves of liquidity.

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The only checks to over-issuance that still remain are: (1) the Central Bank's discount window (i.e. the commercial banks can use rising customers'deposits to pay-off their official loans, but these sums are small); and (2) the foreign exchange market. The net result is that monetary authorities have lost control of the volume of credit and hence the exchange rate, although they still retain control of liquidity, or more exactly, its key component, the volume of currency in circulation, i.e. legal tender. Put even more bluntly, Central Banks ignore both the quantity and increasingly the quality of bank credit, by allowing banks and other financial institutions to engage in more sophisticated and esoteric asset/liability and risk management.

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Arguably, without funding pressures and with the 'promise' of ready supplies of liquidity, major banks have been 'officially' encouraged to accelerate their asset growth and, consequently, expand into more risky areas. Indeed, so fast has their lending capacity grown that banks have struggled to find new borrowers; hence, their moves into securitisation and sub-prime.

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the massive growth of credit has financed growth in the increasing absence of strong profitability. Poor global profitability results from China's low rate of capital productivity. Again like in the 1980s Japanese bubble and 1990s Technology bubble, equity investors are seduced by growth and ignore profitability. Thus, credit soars and profitability and real interest rates slide. The nine-fold rise in credit since 1985 must be set against the 380 bps drop in real bond yields. Thus, investors should bristle at the risk of any upcoming insolvency. Often solvency problems can be buried if enough liquidity is pumped into the financial system.

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Illiquidity is causing Central Banks to inject funds, and encouraging asset markets for one final assault. If we are correct, an inflation problem is building; and if we are unlucky enough, this may hit markets concurrently with a major insolvency problem ...not in Florida real estate, but among Chinese banks.