As the World gets bigger, it seemingly becomes ever more volatile.

Financial markets are volatile. Capitalism is, at heart, a financing system, or more correctly a re-financing system that funds a vast accumulation of capital investment. Refinancing is controlled by Central Banks through their liquidity provision. Think of financial markets as serving two functions: in their early stages they act as capital raising mechanisms, but in their later years they become capital distribution vehicles, and sometimes even capital destruction vehicles when they are starved of liquidity. Capital investments have to be re-financed, sometimes several times, before the new production comes on stream.

The weakness of Capitalism originates in this refinancing process. The mismatch between the actual duration of llong-dated assets and the shortened time horizons of nervous investors causes financial market panics as investments are liquidated.

(...)

The cycle of liquidity supply is linked to the business and profits cycle. The drive for profits forces businesses to invest in long duration and higher productivity processes. Funds are provided but generally have to be re-financed, sometimes several times, before the new production comes on stream. The capitalist business cycle is largely a cycle of asset duration rather than economic growth, which entails frequent changes in the structure of capital assets and in the time that money is tied up.

(...)

So, the underlying causes of this crisis are 180 degrees different from the popular belief. They have little to do with poor investments by banks and absolutely nothing to do with the so-called Asian ‘savings glut’. Rather the problems lie both in Asian and largely Chinese overinvestment, not oversaving, and in the fragile funding structure or low quality of Western banks’ liabilities, not banks’ assets.

Low capital profitability encouraged yield hungry investors to leverage skinny returns. Many Western banks found ample new finance to feed this leverage in the wholesale money markets and so shunned their traditional retail deposit
bases. Starved of liquidity by a combination of hoarding and former Central Bank restraint the wholesale markets have now closed, thereby preventing essential re-financings.

(...)

Often the role of credit is hard to see because not only have policy-makers traditionally ignored credit controls (and hence credit monitoring) but the distinction between credit and money is often fudged. Liquidity is very different from the money supply measures beloved by economists and defined as bank deposits. This brings us back to our earli er distinction between sources and uses of funds.

(...)

Traditional banks now compete to provide credit alongside other financial institutions from the so-called shadow banking system, such as mortgage banks, hedge funds, finance houses and investment banks. These institutions provide new credit; contrary to conventional wisdom , they are not simply intermediaries. Money supply measures exclude the deposits and loans of the once rapacious shadow banking system. One reason for this is that the shadow banking system does not make loans and accept deposits in the usual way. For example, credit can be advanced via the purchase of securities, and sometimes though derivatives. Similarly, funding for new loans can come from the wholesale money markets and from capital issues rather than from depositors.

(...)

In short, there is more to credit than traditional bank loans, and certainly far more than signalled by bank deposits. The size of the financial system’s balance sheet has swollen so much of late, both because of new lenders and because of new instruments, that monitoring the deposit liabilities of banks is no longer a sufficient guide to the sources of funds, i.e. means of purchase. Take the US financial system as an example. Latest data on US M2 money supply, i.e. the checking and time deposit accounts of US banks, totals some US$8 trillion. However, total US credit extended by banks and shadow banks through both traditional loans and short -term securities exceeds a whopping US$22 trillion, or roughly three times bigger than so-called money supply, and it has been growing roughly twice as fast. Therefore, it makes more sense to directly measure flows of new credit. This is what we do.