DeciBio Insights

The Financial Crisis: Of Lasix and Liquidity

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In October 2008, as Lehman Brothers teetered on bankruptcy, the U.S. financial system went into septic shock

Reprint of a financial times blog contribution: 
http://blogs.ft.com/economistsforum/2010/02/the-financial-crisis-of-lasix-and-liquidity/

In October 2008, the flow of money stopped. As Lehman Brothers teetered on bankruptcy, the US financial system went into septic shock – from toxic assets representing worthless derivatives and collateralised debt obligations. To capture the gravity of the situation, the media latched onto metaphors.  Warren Buffett called that October the economic equivalent of a Pearl Harbor.

While Buffet’s martial analogy serves to highlight the fall in the inter-institutional lending, a more apropos analogy is that the financial system found itself in the intensive care unit with the diagnosis of septic shock.

Using a medical metaphor to complement Buffet’s martial one can better illustrate the diagnosis, treatment, side effects, and prognosis of fiscal policies that have been implemented. Before exploring why sepsis is an apt analogy, first a brief lesson on why sepsis is so harmful.

The underlying problem of sepsis is vasodilation, a process where the veins that allow the flow of blood dilate. This dilation causes the flow of blood to become markedly reduced. The reduction in flow means reduced perfusion and, more critically, reduced delivery of oxygen to vital organs such as the brain and kidney. To borrow a plumbing analogy, it’s as if the pipes that bring water to your kitchen faucet get bigger, causing the flow of water to turn into a trickle because there is reduced water pressure.

Returning to the cascade of events following the demise of Lehman Brothers, money flow did come to a stop as the financial pipes became so enlarged by a lack of inter-institutional trust. In the name of self-interest, banks decided it was better to shut down the flow of money and keep their own pool of funds. This decreased perfusion of money on Wall Street transferred over to Main Street as the main organs of America, the Mom and Pop businesses and individuals, became starved of oxygen money triggering a negative feedback cycle: a recession.

A second terse Intensive Care Unit lesson: how to treat sepsis. The main principle behind sepsis treatment is to pump the body with liquidity until perfusion goals are met so that the brain and kidney do not become ischemic (lacking blood supply) and eventually necrotic. This lesson was never properly understood by the Federal Reserve which once decided that contracting the money supply would treat lagging business confidence. A reduced flow of funds not only exacerbates the disease process and but would have theoretically set off something like the second Great Depression in 2008.

So far, the financial team of Ben Bernanke, Fed chairman, and the Federal Reserve have responded to the septic mistrust by pumping the financial system full of liquidity. They made the right temporary clinical decision.

As the financial system is being tanked up with fistfuls of dollars which are printed out of thin air, it is third ICU lesson that is the most important and illuminates the potential side effects and prognosis of the American economy as we try to recover. The third ICU lesson is simple: there is such a thing as too much.  Tanking up the system and not keeping score of where the fluid or funds are going can cause a dreaded ICU side effect called flash pulmonary edema, where the lungs become clogged with fluid. With no oxygen circulating, the patient suffocates.

The financial equivalent of flash pulmonary edema would be hyperinflation. In order to avoid and treat flash pulmonary edema, a drug called Lasix is administered to diurese the patient. Rather than going on blind faith to assess that the system has enough liquidity, ICU physicians use a metric called the central venous pressure to guide their decisions on when there is enough liquidity in the body.

Hopefully, Bernanke et al have some reliable metric to determine when enough liquidity is given and possess the financial equivalent of Lasix (a diuretic) to removethe excess. Fluid is not a long-run substitute for blood, but that is a lesson for another time. Otherwise, the prognosis of the US economy could call for massive Zimbabwe-style inflation, where it is arguable the treatment is worse than the disease.

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