The Global Economic System: How Liquidity Shocks Affect Financial Institutions and Lead to Economic Crises. George Chacko, Carolyn L. Evans, Hans Gunawan, and Anders Sjöman. FT Press 2011, pp.269, $34.99 It has been nearly three years since Lehman Brothers filed for bankruptcy protection. Unemployment nevertheless remains close to 10%, the housing market has not [...]
The Global Economic System: How Liquidity Shocks Affect Financial Institutions and Lead to Economic Crises. George Chacko, Carolyn L. Evans, Hans Gunawan, and Anders Sjöman. FT Press 2011, pp.269, $34.99
It has been nearly three years since Lehman Brothers filed for bankruptcy protection. Unemployment nevertheless remains close to 10%, the housing market has not yet recovered, and recent college graduates find themselves underemployed and often living back home with their parents. Despite the bailouts, deficit spending, and the Federal Reserve’s policy of quantitative easing, there has yet to be a recovery from the financial crisis of 2008. Why is this the case? Did the Obama Administration so completely fail to respond adequately to the faltering economy? Was there too much federal government intervention or too little?
Although it does not attempt to answer these questions directly, The Global Economic System: How Liquidity Shocks Affect Financial Institutions and Lead to Economic Crises does provide a framework for understanding what exactly transpired in 2008. It also helps explain, to some degree, why the anticipated recovery did not come to fruition as policy makers had planned. Co-written by four experts in economics and finance, The Global Economic System is a monograph that would be inaccessible to readers without a prior knowledge of basic economics and recent financial history. The authors themselves acknowledge that the book was “written assuming that the reader has some familiarity with finance and economics.” That said, an advanced undergraduate business school student would be able to learn much from this recent work of scholarship.
Chacko and Evans (both of Santa Clara University), Gunawan (Skyline Solar), and Sjöman (Voddler) draw upon the concept of a peso problem, referring to a hidden – and generally unobservable – risk factor in financial market data. The authors argue that, during the period prior to the 2008-2009 economic crisis, there was “an extremely pervasive peso problem, touching our entire society. It is present in every market (both financial and nonfinancial), it affects most financial institutions ranging from banks to hedge funds, it has always been there, and it will always continue to be there. This latent risk factor is liquidity risk.”
The purpose of their work, in the authors’ formulation, “is to not only provide a detailed description of the concept of liquidity risk but also to lay out how this risk affects financial institutions and thereby gets transmitted into the global economic system.” They attempt to do so through case studies of the Great Depression, Japan’s Lost Decade, and what the authors term The Great Recession (of 2008 to the present).
For those readers unfamiliar with liquidity, liquidity risk, liquidity shock, and other related concepts, Chapter 2 provides a comprehensive and readable overview. The authors utilize graphs and discuss how an understanding of bid and ask curves helps to illuminate the concept of liquidity. Liquidity risk, in their formulation, refers to “the risk of facing an illiquid market for a good or a financial security.” The authors provide a useful, although perhaps a slightly too technical, definition, of liquidity shock as “a dramatic increase in the price volatility of a security and a dramatic decrease in trading volume with more sellers than buyers for the security, and it leads to a dramatic decrease in the price of the security.” These are not easy concepts to define; the writers do an admirable job with difficult material.
Although tangential to the larger thesis, the authors’ discussion of how insurance companies utilize what they term liquidity-driven investing is worth consideration. They define liquidity-driven investing (LdQI) as “an investment approach used by many institutional investors that have liability streams to capitalize on liquidity risk premiums in financial markets.” More significantly, they demonstrate how an insurance company is able to use this approach. The authors also discuss how such a company can, under certain circumstances, become a distressed seller.
In Chapter 5, the authors employ a six-stage approach to demonstrate how, during the Great Recession, a liquidity shock spread from the financial sector to the nonfinancial sector. The stages are as follows: an initial trigger; a change in the liquidity demanded throughout the economy; changes in bank balance sheets; how banks change their activities to bolster their balance sheets; fewer funds available for assets with low liquidity and increased investment in highly liquid assets; and real effects observed throughout the economy.
As they write in their Conclusion, “[t]he key to understanding how a liquidity shock spreads is the transmission process that occurs via the normal responses of banks to changes in their balance sheets and funding availability.” In their formulation, during Great Recession, the initial liquidity shock was in the MBSs (mortgage backed securities) and the derivatives market. The transmission of this liquidity shock from the financial sector to the nonfinancial sector resulted in a credit crunch.
Given that the authors spent well over two hundred pages discussing liquidity shocks, one would have thought they would have had more salient policy recommendations for how best to avoid, if not lessen, a liquidity shock. The authors do rightly acknowledge that changing bank accounting rules to prevent banks from liquidating their assets in response to a sudden reduction of capital merely results in “zombie banks – banks that are in reality troubled, or even dead, but they are still seemingly healthy by accounting standards.” They provide brief discussions of bank nationalization, debt guarantees, central bank lending, monetary policy, and fiscal spending.
While acknowledging that the approaches that could prevent liquidity crises also may, in turn, inhibit economic growth, the authors ultimately conclude “in the end, it may be the case that liquidity crises go hand-in-hand with an efficiently functioning economic system.” Some readers will find this conclusion, while technically correct, less than satisfactory. Others will recognize that the authors are just being realistic; liquidity shocks are, in a word, normal.
In conclusion, The Global Economic System is a comprehensive study of how liquidity risk helps to explain the financial crisis of 2008 and the ongoing recession. Those working on the Hill on financial services reform would have a lot to gain from taking the authors’ thesis seriously.
Jon Lewis (c) 2011