Liquidity and Palliative Care.

Dear,

Just 7 months ago, the risk of collapse in the markets due to the Eurozone debt crisis was reminiscent of the uncertainty and panic of November 2008.

Seven months later the coordinated action of central banks, injecting liquidity to the financial system, has apparently eliminated the risk of collapse in the financial markets.

Unfortunately, this has never been a liquidity crisis but a solvency one. The real issue is not the stability of the Financial Markets; that’s just a symptom of a much more serious illness.

The real issue is the exhaustion of the economic model based on wasting capital, mainly represented by the scarcity of financial solvency and natural resources.

We’ve seen two approaches for dealing with this Economic and Financial crisis.

- Expansive approach described by injecting liquidity or what’s the same but in a different format, implementing stimulus packages. For some economists; this is the right answer for a fast economic recovery. According to them, if there are no inflation signs, a treatment based in injecting liquidity does not have contraindications. US Government and the FED have been the champions of this approach.

- Contractive approach described by implementing austerity programs which must increase the confidence of the markets. In this case the contraindication is deflation and pain. German government has been the main champion of this approach.

In my opinion both approaches are wrong. 

The US approach forgets that inflation is an average, and while some assets have not increased significantly its price (housing for instance) other critical assets, like Oil, have seen a dramatic rise in their prices. By the way, as commodities markets are traded in US$, the instability of US$ is affecting everybody, and it can have (and in my opinion it will have) a serious impact in the use of US$ as global trade currency in the middle term.

The contractive approach is also wrong, as combines the positive effect of reducing the size of the economy to more sustainable levels, with draining resources from some activities with real potential of sustainable growth generation. As a consequence, the countries affected by this approach are suffering a severe depression (southern European countries) or a slowing down of their economic growth (northern European countries, including Germany).

Again, the answer is efficient Capital Management. Capital allocation is becoming the most critical activity and it cannot be driven anymore by an economic model based in cheap Capital (represented by abundant natural resources and credit orgy). This is an old business model based in volume, when all the activities were profitable and it was not important if they were efficient and sustainable or not.

Now, the scenario is different. Capital scarcity is making us distinguish between efficient and long term sustainable activities, and inefficient and purely speculative investments; that’s the exit strategy of this crisis.

Current stability of the financial markets?

This is just the result of the palliative care represented by the liquidity injection of the last months, it’s temporarily alleviating the symptoms, but as the illness is very serious, they will return. 

Looking forward to read you comments.

K. Regards,
Ferran.