Military leaders talk about the “fog of war” – the condition of fundamental uncertainty that marks combat. The recent credit and liquidity crisis has revealed a similar condition in financial markets, because no one, not even central banks, seems to understand its nature or magnitude.
It is often suggested that what is called the “subprime” crisis was the result of lax monetary policies that led to excess liquidity in financial markets. But there is an obvious paradox here, because how can an excess of liquidity result ultimately in a shortage of liquidity that has to be made up by central banks?
In fact, monetary laxity can be a symptom not of excess liquidity, but of excess saving. This is reflected in increasing income inequality in much of the developed world, and the vertiginous surpluses of oil-producing countries and Asian nations. The emergence of sovereign wealth funds like those of China and the Gulf states to invest the savings of these countries’ budget surpluses is but the tip of the global excess savings iceberg.
Whereas excess liquidity is inflationary and calls for higher interest rates, excess saving is deflationary and calls for lower rates. This brings us to the dilemma faced by central banks. When central bankers cannot avoid a crisis – or when they contribute to create one – their fundamental mission is to do everything in their power to contain its impact.