> BUT CRUCIALLY, the bank loses liquidity. It has $100 more in demand deposit
> liabilities relative to its reserves and relative to its capital than it
> started with. And this really matters because the bank has a limited
> capacity to extend its liabilities relative to these things. The limits are
> both prudential and legal. So there really is a scarcity involved here, even
> though it is in a complex relationship with income flows involving
> production in the 'real' economy.
>
> To keep developing this story, you'd have to follow what Charles does with
> his extra liquidity, the real _and_ monetary income flows resulting from
> your company's purchase of investment goods, the bank's asset and liability
> management and its interaction with monetary policy, and so on... and it
> quickly becomes apparent how impossible it is to talk about these things
> without a comprehensively macroeconomic perspective.
>
You're right that my story involving just two people and a bank can't give a complete picture of what's going on and that a macroeconomic analysis is needed. I believe I provided the macroeconomic analysis when I showed that finance has not absorbed more real resources. I think your point is that, while this is true, Ive neglected an additional factor - liquidity - which is scarce in some sense. I think my response is that I don't really agree that liquidity is scarce. Here's how you put it:
> And this really matters because the bank has a limited
> capacity to extend its liabilities relative to these things. The limits are
> both prudential and legal.
Suppose for the sake of argument that the bank could hold stocks as
assets. Now suppose that the stock market rises. The bank's assets are
now worth more, so it has more capital. Now it can expand its
liabilities, creating more money/liquidity - which causes the stock
market to go even higher. Repeat, etc. Under this scenario, there is no
liquidity scarcity at all. This describes the U.S. financial system
pretty well, because while commercial banks aren't usually allowed to
hold a lot of risky financial assets, broker-dealers are. And they play
an enormous behind-the-scenes role in generating and supplying the
liquidity necessary to fuel asset bubbles. Repos are the key market here.
> Values of fictitious capital
> (and also of 'real' durable assets like real estate) can grow out of
> relation to the future income flows they are capitalising regardless of the
> state of general profitability - in fact it is more likely to be associated
> with high rates of profit. This is not necessarily due only to manias and
> irrational exuberance, but can in fact grow out of 'too much
> saving/profits'.
I'm glad you wrote this - it has reminded me to apologize for being dense when you first raised this point a few days ago. I think I understand what you mean now. An autonomous increase in saving creates demand for financial assets; the demand is fully met, but only at a lower interest rate than prevailed before. This can cause asset bubbles. Do I have the basic idea right? If I do, I agree with it up until the last sentence. Lower interest rates cause asset prices to go up, but they can't in themselves cause a bubble. When interest rates tick down one notch, asset prices tick up one notch. When rates tick down another notch, prices tick up another notch. But this is not a bubble yet because it's not feeding on itself. Just as it's not a bubble when stock prices rise in proportion to corporate profits, it's not a bubble when they rise in proportion with the fall in interest rates. It's only when prices begin to rise to higher and higher levels that can't ("rationally") be justified by either expected income flows *or* current liquidity conditions that a bubble has developed. Low interest rates can provide the dry weather propitious for an asset-market wildfire. But to make the fire spread, it needs a constant supply of oxygen - i.e., bubble psychology.
SA