The financial crisis through the clinical prism of blood composition and stem cellsReprint of a financial times contribution: http://blogs.ft.com/economistsforum/2011/05/the-financial-crisis-of-blood-and-fungibility/With the demise of Lehman Brothers in 2008 and the subsequent septic shock that stemmed the flow of liquidity in the financial system, the Federal Reserve responded with an unprecedented infusion of liquidity that has continued into this year.However, this heightened rate of infusion is scheduled to finish in July. With the looming end of the second dose of quantitative easing (QE2) the media has latched onto the analogy of Bill Gross, Pimco’s co-chief investment officer, of QE2 and subsequent liquidity pumping efforts as a Ponzi scheme. The recent exit of Pimco (one of the world’s biggest bond fund managers) from US Treasuries underscores Mr Gross’s huckster metaphor.While there is an element of warranted alarm, seeing the crisis through the clinical prism of blood composition and stem cells may provide a more balanced view.First, blood is an amazing concoction. Although blood is mostly composed of water, its non-water factors deliver oxygen, fight invaders, and clot wounds. Likewise, credit or financial liquidity, although composed of paper bills or electrons, can deliver confidence, build an army, and restore dilapidated infrastructure.The lesson in this simile is that the water in blood or the financial solvent of bills or electrons is not the special factor, but the vehicle to deliver those special factors. Confidence intrinsically does not derive from the solvent. Instead, confidence comes from special factors that John Maynard Keynes called “animal spirits”. However, as long as the solvent of money carries confidence, the con game that Mr Gross warns us against can continue as a confidence game.Second, whether the end of QE2 will result in a con versus confidence game lies in the lesson of hemodilution (increase in fluid content of blood) and what Mohamed El-Erian calls the “new normal”. While the Federal Reserve cannot conjure up confidence and Keynesian animal spirits, it has created more solvent through QE2. The conventional understanding is that more solvent leads to hemodilution.However, experienced clinicians know that more solvent does not necessarily lead to hemodilution if:

1. the solvent does not go into the blood system and/or
2. whether homeostasis takes place: ie the “new normal” produces more special factors to compensate for the additional solvent.

The bulk of the newly conjured solvent is currently trapped on the balance sheets of banks, away from the vasculature. But once the liquidity seeps into the blood system, hemodilution or inflation can occur if more special factors are not produced.This leads us to the third lesson: where do these special factors come from? In the human body, the special factors that make blood, the essence of life, are hematopoietic stem cells. These amazing self-renewing cells divide and manufacture special factors such as red blood cells for oxygen transport, lymphocytes for defence and platelets for clotting.In the body economy, the special factors that make liquidity valuable are the fungibility of manufactured goods and certain services. Exportable and fungible goods and services such as such as trucks, guns, and mortar are the physical manifestations of these special factors. The body economy’s stem cells are the entrepreneurs who develop new products, build factories, and sell services for new markets. We will see if the American body economy is up to the task of healing and self-renewal.