Too Much Liquidity: The Source of the Trouble

Abstract

Excessive liquidity has financed a series of bubbles over the past ten years. Central banks have not tried to prevent bubbles from ballooning but have raised interest rates once inflation exceeds the target or there is persistent overheating, thereby pricking the bubble. Moreover, central banks have added liquidity every time a bubble has burst and cut interest rates to offset the deflationary gap. By doing so, central banks have prevented the necessary deleveraging and have perpetuated the excessive liquidity, thereby sowing the seeds for the next bubble. This explains the creation of and subsequent pricking of successive bubbles. The housing bubble is a transformation of the internet bubble and the commodities bubble a transformation of the housing bubble. The story keeps repeated, but in every cycle liquidity makes another leap forward.