Global Easy Money
In a recent speech, David Dodge (Governor of the Bank of Canada) worried that because the world is awash with liquidity, it is becoming increasingly difficult to manage Canadian monetary policy.
If the Capital-Asset Pricing Model has any validity (I think it's pretty good for most situations), it looks as if Dodge is concerned that the Security Market Line is shifting downward and becoming flatter. What he seems to be saying is that when returns drop as a whole, some people are willing to accept a bit more risk, which implicitly assumes "normal" shaped indifference curves in the risk-return trade-off, I guess.
There seems to be a lot more global liquidity out there than one might have anticipated," Mr. Dodge said. Spreads of high-risk investments are "pretty narrow" and don't properly reflect risk, he warned. In other words, issuers of high-risk debt can get away with paying historically low prices to get investors to carry their debt.Because of the phenomenal growth in communication and technology, the supply of lendable funds to any one country, especially a small one, is highly elastic. A slight change in the interest rate, ceteris paribus, can cause massive tides of funds to leave or enter the country until interest rates and exchange rates adjust. These changes, including the rate adjustments, happen quickly, with the tendency for the supply of lendable funds to be horizontal, not vertical as we were all taught in our good old Keynesian models of the 1960s.
If the Capital-Asset Pricing Model has any validity (I think it's pretty good for most situations), it looks as if Dodge is concerned that the Security Market Line is shifting downward and becoming flatter. What he seems to be saying is that when returns drop as a whole, some people are willing to accept a bit more risk, which implicitly assumes "normal" shaped indifference curves in the risk-return trade-off, I guess.
...there is so much money chasing a limited number of investment opportunities, driving down aversion to risk - especially for high-risk debt issuers such as companies with junk bond status or emerging market economies. As a result, spreads (a proxy for the price that bond issuers pay investors to carry their debt) have eroded steadily and steeply over the past five years, leading many economists to warn that they are too narrow, and that investors have become complacent. "That is a real issue ... a very, very real problem and potentially a real concern," Mr. Dodge said...He is worrying too much. Even if growing global liquidity might pose some problems, what's he gonna do about it? slap on exchange controls? I sure hope not!
Category: Economics, International Trade and Finance, Macroeconomics, Money Posted on
Monday, May 7, 2007 at 1:35am
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1. Once again -- no more scarcity. The economics of abundance.
2. If he knows so much about market conditions, why isn't he in it, making a killing?
Mentioned are:
1. Difficulty of conducting monetary policy. (Should I worry or should I cheer?)
2. The "That is a real issue ... a very, very real problem and potentially a real concern" paragraph where there's no explicit problem, as far as I can tell.
OK, so there are a lot of savings out there, driving interest rates down and making relatively risky investment projects feasible. And?
More and more economists (even largish ones) will start to look like the "small, open economy" parable. Is that bad?
All this liquidity, in and out, causes some volatility. Granted. So why not simply lean on the hope that futures and options markets will take care of some of that?
Why worry? Explain it to me like I'm a 2 y/o, please.