The Potential for Illusion

We are indebted to our friends in the world of academia for highlighting the following potential financial illusion. The term financial depth was coined to explain the extent of money or financial assets that an individual; organisation or country has access to. It has been a long-held view that the greater the financial depth the faster the economic growth. Recent studies suggest that this belief is an illusion – or maybe not!

The difficulty stems from the type and quality of money that’s on offer. In the normal course, liquidity (or the free-flow of finance) is a more advantageous tendency because the finance will be used to consume and invest – thereby generating growth. But such consuming and investing is predicated on risk – risk cost to the supplier and risk cost to the consumer. Although the fulcrum in this risk game often shifts over time depending on economic variables such as price; a pivot still exists between both parties. As long as there is a perceived advantage one party will continue to supply and the other party will continue to consume/invest. The advantage may swing a little to the left or right of centre but this premise was thought to be an all-embracing golden truth – not any longer!

Recent findings make the case that once financial depth reaches and exceeds a certain optimal level further financing reduces rather that increases growth. If true, this is a profound finding. It has implications not just for personal borrowers but for the world economy at large. For example, if the money-printing of the Federal Reserve has reached the optimal level then further money supply will depress growth and defeat the Fed’s aims.

The type and quality of the Fed’s money is identified as the issue. There is no risk cost to the Federal Reserve in printing its own currency. (In fact, it doesn’t even print it. It simply adds several zeros to the on-screen balance sheet – painless!!). Similarly, the risk cost to the borrower is skewed towards zero. Incredibly, in this environment both parties have a perceived advantage and could conceivably continue on indefinitely and generate significant growth. But this is not happening in practice.

The Federal Reserve (and other Central Banks in the western world) has seen its Quantitative Easing Programme (money-printing by another name) fail to deliver economic growth. It has left Central Bank Governors and by-standing politicians very bemused. It has left experienced economists scratching their heads in disbelief. It has left ordinary consumers extremely disillusioned.

If the recent research is correct it explains why the corner-stone belief that increased money supply inevitably leads to growth needs some serious re-examination. Humans are very reluctant to admit that a fundamentally-held supposition is wrong because it upsets all of their life’s work. Even the academics behind the recent studies are careful to make their case that while something is amiss, they also point out that they cannot prove it mathematically – and, therefore, due caution is warranted. The illusion is complete!