Liquidity and confidence.

• Author: Smick, David M.
• Position: Global economy - IMF/World Bank/G7 meeting

It is popular these days to fret publicly about the ocean of liquidity now swirling around global financial markets. Morgan Stanley economist Stephen Roach, featured prominently in a recent Barron's magazine article, has stressed that "this liquidity-driven era of excesses and imbalances could well go down in history as a huge failure for modern-day central banking." Left unsaid, of course, is that Roach has sounded like a broken record on the disaster theme for many years.

The future of the world economy may well depend, nevertheless, on how policymakers come to terms with the liquidity issue. Is today's ample liquidity merely some awful trick by greedy, leveraging financial wizards looking to achieve short-term financial gain before they abruptly cut and run, leaving the naive central bankers to clean up the mess? Or does the liquidity reflect true growing value in the global economy?

Traditional economists define an asset's liquidity in terms of its ability to be transformed into another asset without loss of value. This notion of "money" is less than satisfying. Liquidity represents more than just a summing up of asset values. During the Asian and Russian financial crises in 1997-98, for instance, global liquidity dried up overnight, a frightening scenario as the high-yield corporate and emerging market bonds collapsed. When pared down to its essence, it may be that liquidity, when all is said and done, is nothing more than confidence. Federal Reserve Governor Kevin Warsh in a recent speech made this case: "When the [highly negative] outcomes are either highly improbable or, at the very least, subject to reasonably precise measurement, the conditions are ripe for liquidity to be plentiful."

Will today's wealth of liquidity soon dry up? It all depends on the level of confidence in the global capitalist model. It depends on the confidence in the ability of globalization to deliver economically. The United States is particularly crucial in that regard because the rest of the world is likely to follow in America's footsteps. There are a number of unknowns and by far the most crucial is whether U.S. politicians allow the American economic and financial systems to slip progressively into a protectionist mode. Thus, the answer to the liquidity question may well depend on the global commitment to liberalized financial markets and free trade, beginning with the United States.

Yet nothing about the future will be simple. We are living in an...