Until the Next Crash

The populist revolt is not against the crash, or even its immediate aftermath, but against the nature of the recovery.

“OF THE MAXIMS of orthodox finance,” wrote John Maynard Keynes in 1936, “none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities.”

When Keynes wrote these sentences in The General Theory of Employment, Interest, and Money the leading stock exchanges of the world, New York and London, had placed liquidity near the center of their national investment markets. It was a virtue for investors to hold a security for which there was always a willing buyer. That way an investment could quickly be converted into money, and safely guarded until the next purchase of yet another security.

Eight decades later, global finance is feeding off the potential convertibility of capital assets—liquidity—to an extent that Keynes could scarcely have imagined. Today’s global macroeconomy is stitched together by the balance sheets of the great financial corporations of the world. There are no more than thirty banks that matter, all of them entwined with a vast allied network of structured investment vehicles, institutional investors, and asset managers. These institutions prefer to invest in assets from which they can always confidently depart. Designed by banks with that purpose in mind, more and more assets have the liquid attributes of money. The result is that capital is extraordinarily mobile. Today, it moves in and out of different asset classes (stocks, bonds, real estate, et cetera), as well as in and out of different national economies, on a whim.

The consequence is that as vast sums of capital and credit rush around the world in digitized bits every millisecond, the global macroeconomy suffers from a lack of long-term productive investment. Economy-wide productivity gains have disappointed; infrastructure has dilapidated; fossil-based energy systems have remained stuck in place. Keynes called liquidity a “fetish” because liquidity is a relative quality of a capital asset. Yet long-term investment is an aggregate concept. If the owners of capital prefer to hold liquid securities instead of long-term illiquid investments, capital will cycle between the two liquid options of short-term speculation, which occasionally shades into long-term investment, or nervous cash hoarding. Liquidity is a fetish, because for the community as a whole the concept makes no sense. What looks like liquidity to an individual owner of wealth means a decline in the aggregate rate of long-term investment for the macroeconomy—fewer jobs, less wealth, and more wasted human potential.

How did liquidity move to such a central place in capital markets? In the immediate postwar period, even in capitalist economies, many banking systems were not organized around the doctrine of liquidity. Finance followed something more like a national “public utility” model, in which banks deliberately placed long-term blocks of credit into productive enterprise. But there was a flaw in the postwar international economic system: US dollars accumulated outside of the US. US cold war military commitments in Europe, the Soviet Union’s desire not to deposit its dollars in the US, and imbalances in US and European trading relationships were the leading reasons for the piling up of so-called “Eurodollars” in the City of London. At the 1944 negotiations over the postwar international monetary system in Bretton Woods, Keynes himself had wisely proposed a special fiat currency to clear binational trades, and thus forestall the possibility of currency accumulations. He named it the “Bancor.” But the Americans, determined to tie the postwar world economy to the dollar, nixed the proposal. Eurodollars became pools for cross-border speculation—a nearly unregulated onshore/offshore financial playground.

By the 1960s, London had become the hub of global currency speculation, and the home of a dollar-based wholesale money market outside US jurisdiction. All this activity in London helped bring down the Bretton Woods system of fixed national currencies pegged to the US dollar, which was pegged in turn to gold at $35 an ounce. In the midst of national industrial malaise in the wake of the collapse of Bretton Woods in 1971, the global economy entered the world of floating currency exchange rates. To cope, banks began to engineer and trade all manner of financial derivatives to hedge their positions and those of their clients against potential exchange- and interest-rate volatility. Financial securitization, in which banks engineered one newfangled security after another, began to flourish in the 1980s, when the City of London once again became an innovative laboratory. Many of the big players in this century’s financial crisis were headquartered there, including AIG Financial Products, which wrote many of the credit-default-swap insurance contracts on US mortgage bonds that would prove so catastrophic in 2008.

Formerly at the margin, the London Euromarkets moved to the very center of the global economy. How exactly this happened is difficult to say, since a full historical account of the transformation has yet to be written. There are reasons why it has remained largely offstage. Partly this is due to the way many economists juxtapose finance against an underlying “real” economy. Similarly the celebration of the “free market” since the election of Thatcher and Reagan has only obscured the operations of a global financial system that has actually become a tightly networked cross-border cartel of financial corporations that trade mostly with one another. In commentary, there is an obsession over national economic rivalries and differences, with the US facing off against Japan, say, or a rising China. But the global economy is not best depicted as so many national economic islands, connected by oceans of trade in goods. It is more accurate to think of it as trillions of dollars of highly leveraged short-term financial bets made possible because of the presence of liquidity—willing buyers for all securities.

Since the 1980s, leading members of the financial community have begun to recognize that liquidity is the lifeblood of the new global system. Advocates promised that capital would intelligently flow to where it most belonged, earning the highest possible return, benefiting us all. All risks, they said, could be hedged. But left to their own devices liquid capital markets have been rather dumb masters. The 2008 financial crisis was, by all accounts, a “liquidity crisis,” in which interbank lending markets seized up after the banks began to doubt the quality of the US mortgage-backed securities they themselves had engineered—in order to sell to themselves. In September 2008, the banks very nearly stopped trading with one another, liquidity evaporated, and global capital markets nearly collapsed. Aggregate private investment plummeted. The global economy tanked. This, the world suddenly learned, was what an economic system built on liquidity could look like.

by Jonathan Levy