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The behaviour of commodity prices is another flaw in the smooth logic that has fuelled these bleak economic forecasts. Oil prices have soared, rather defying suggestions of weakening aggregate demand. But more importantly, oil prices have moved higher relative to other commodities, and particularly gold. Thus, the gold/oil ratio recently fell below 7x, or close to its typical 5x peak value usually seen during periods of strong economic growth and sound credit. The opposite periods of insolvent debt and skidding economies sees investors shun oil and scramble for the safety of gold, pushing the gold/oil ratio to skyhigh values of 40x. Not this time! Figure 6 shows that this happened in the 1870s Great Depression; the 1930s Depression, and the 1987 Crash.
Thus, our problems concern illiquidity, not insolvency. In our view, the World has suffered a re-financing crisis over the past year largely brought on by Central Bankers’ preoccupation with fine-tuning interest rates, and their consequent mismanagement of liquidity. The lesson of twelve turbulent months is that liquidity is critical. Central Banks seem to have finally got the message. The ECB got there first, but the March and April announcements by the US Federal Reserve and Bank of England, respectively, show that this understanding is widespread. (Come on Japan!) The evidence is clear from the Fed’s own daily operations in the repo markets, shown in Figure 7. Our estimates show that the Fed recently upped the scale of its daily injections (rolling 14-day total) to around US$150 billion, or well-above the near-US$100 billion six-month trend. Note that periods of recent financial market weakness all occurred immediately after a slump in Fed liquidity injections.
A recent speech by Fed Chairman Bernanke fesses up to these Central Bank errors1. What remains unsaid is exactly why it took seven months to understand the problem was a lack of liquidity! The Fed still hides behind the moral hazard argument to justify not providing cash too readily, but the real problem is that too many key Central Bank positions are being taken by ex-academics, rather than ‘market men’ who understand how the financial system really operates.
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