> 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.
>
I think we're getting close to agreement here...
But one issue - stocks a bank holds do not count as a bank's capital. In fact the whole point of capital requirements is to limit the acquisition of assets to some multiple of capital - with core capital being money _originally paid for the bank's own stock_ plus accumulated non-distributed profits. Unrealised capital gains on stocks can count to some extent as accumulated non-distributed profits, but at a heavy discount. Under US regulations, for example, they are counted at only 45%, and count only as Tier 2 capital. Because there are Tier 1 capital requirements, and unrealised capital gains don't count for Tier 1, there's a strict limit to how much stock market bubbles allow bank expansion, even if banks did hold much stock.
You are right though that broader markets in which the banks trade open up some major flexibility in overall systemic liquidity. But it is still limited; and worse, it's limited in unpredictable ways so that banks can overstretch without realising they are overstretching. To me, Minsky's the man on these relationships, he pointed out the stretching of liquidity made possible by off-balance-sheet repurchase agreements between banks and other financial institutions way back in the 1950s. But he was also always clear that the stretching could only go so far.
Actually we should recognise two limitations on bank expansion. Liquidity and capital requirements. Traditional lender-of-last-resort operations have generally been about liquidity, but since Basel capital reqirements have become more important, which is why governments are being forced to inject equity into banks rather than just help them out with temporary liquidity.
> 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.
Yeah I think we are in basic agreement then. I have agreed all along with your basic point that finance doesn't grow at the expense of real investment (except to the limited extent that finance _is_ real investment, in buildings, wage funds, etc). I just wanted to make the point that there is a sense in which saving/profit from goods and services production can develop a tendency to fuel financial excesses. I like your analogy about dry weather and supply of oxygen, but I would be inclined to reverse which is which. I think of finance in terms of quantities and not just interest rates.
I agree with you that banks and broader financial markets can effectively create money-capital that does not emerge from prior saving. But it is limited in its ability to do this, so that accumulation out of 'real' income flows is still relevant and can be seen as 'too high' as it enhanced the capacity of banks etc. to do this. For example, the flow of funds into the US Treasuries market from Asia, the Middle East etc. 'frees up' some of that relatively liquid end of portfolios that had previously held the Treasuries. Banks see an opportunity at this end of the spectrum and fill it with relatively liquid (for now) mortgage-backed securities. This frees up part of their own asset portfolios that had been locked into illiquid, long-term mortgages. Effectively an increased demand for short-term securities is turned into an increased apparent capacity for the system to hold longer-term, less liquid assets. More funds for mortgages... and you see where this is going. In a sense the fuel for a housing bubble in the US can come from increased accumulation elsewhere - it might not have been possible for banks to increase mortgage funding without having been able to channel value ultimately accumulated elsewhere. At the same time, there never would have been such an increased demand for mortgage finance without bubble dynamics.
Cheers, Mike Beggs