A world of liquidity: the impact of cash-rich companies, countries and consumers; A noted economist traces the evolution of financial regulation, monetary cycles and the recent emergence of strong liquidity and its impact on global growth.

The start of the 21st century has been stressful in terms of geopolitics, but remarkably favorable in terms of global growth. The four years through 2006 enjoyed the fastest global growth since at least the 1960s, helped by strong growth in the U.S. and China and by Japan's emergence from deflation. Low interest rates and high levels of liquidity have been one of the driving forces for this global boom, pushing up commodities and stock prices and reducing credit spreads and defaults.

The roots of this high-liquidity environment were planted in the financial evolution of the 20th century, which saw waves of liquidity and illiquidity, and a rapid evolution of finance and financial regulation. These, in turn, played an important role in growth, the investment process and the role of financial executives in American business.

The 1930s was a defining era in the thinking on liquidity and regulation. The first years of the decade saw liquidity disappear, marked by bank failures and "no credit" signs nationwide. The U.S. Securities and Exchange Commission (SEC) and an active bank regulatory system emerged. Glass-Steagall and Reg Q became household words, at least in the nation's financial community

The wartime economy of the 1940s left the new regulatory framework largely intact, but brought drastic economic change, including full employment, a national debt that eventually reached 100 percent of GDP (nearly triple today's level), inflation and price controls. Liquidity reappeared, especially if it was directed at the war effort and, later, rebuilding.

Economics itself transformed in the 1960s with monetarism and its focus on central banking as a key player in inflation, deflation and liquidity. The '60s also saw the simultaneous federal financing of the military expansion and the Great Society, guns and butter.

This left liquidity and the Nifty Fifty stocks flying high until the gold standard collapsed in '71. It was replaced with floating exchange rates, creating bigger and more frequent liquidity swings--and a bigger role for MBAs. They rose into top corporate echelons in response to inflation, which had drastically changed not only interest rates but time horizons, the carrying cost of inventory, depreciation calculations and taxation of capital gains.

By 1980, it was clear that many of the rules and regulations built in the '30s were obsolete. The wave of excess money and inflation created a wave of regulatory change. Inflation had caused tax bracket creep, bringing many voters face-to-face with the 70 percent tax bracket. In 1981, Kemp-Roth lowered tax rates and indexed them for inflation.

Similarly, straight-line depreciation and capital gains taxation based on historical cost went out of kilter when inflation rose, inviting accelerated depreciation, bigger capital gains exclusions and today's movement for inflation-adjusted basis.

Banking changes were just as big. The Federal Reserve's Regulation Q had, beginning in the '30s, capped interest rates on savings deposits to prevent bidding wars between banks seeking bigger deposit bases. As inflation rose in the '70s, deposits began moving to European banks, which were not similarly constrained.

In 1980, Congress repealed Reg Q, phasing it out through 1986. This was just one of the major changes taking shape in banking and finance, including securitization, capital adequacy standards and high-yield bonds.

The Federal Reserve also took steps to respond to the inflation of the '70s. On Oct. 6, 1979, the Paul Volcker-led Fed shifted to a quantitative monetary restraint. The belated effort to rein in the excess money of the '70s sparked a massive credit crunch in 1980-82. Interest rates rose in nominal terms, outpacing the nation's inflation-goosed nominal growth rate, and they finally rose in real terms, with short-term rates jumping above the 15 percent inflation rate.

After a deep recession, a healthy disinflation process ensued from 1983-96--bringing tight money, lower tax rates and falling commodity prices. It was interrupted briefly in 1989 and 1990 by another credit crunch, this time related to the savings and loan crisis and its aftermath. In general, though, the moderately tight liquidity environment allowed two long expansions as the excess money of the '70s was reined in and prices stabilized.

Bigger and Wilder Swings

While those were wild decades, from a liquidity and regulatory perspective, the swings in the last decade have been arguably bigger and wilder because of the encounter with deflation, though, thankfully with a benign outcome so far. From 1996-2006, U.S. interest rates swung from a high 6.5 percent at the end of 2000 to a low 1 percent in 2003 and 2004 to over 5 percent in 2006, wide by any standards except the '70s. These interest rate swings were shadowed by wide movements in the value of the dollar and, with a lag, the inflation rate.

The latest liquidity swing started in December 1996, when then-Federal Reserve Chairman Alan Greenspan voiced concerns over "irrational exuberance" in asset values. The dollar went on a tear in the days following Greenspan's Dec. 12, 1996 address, delivered at the American Enterprise Institute in Washington. The phrase raised the prospect that Greenspan might make dollars more scarce in order to lean against irrationality. Whether that was his intention or not, the possibility of dollar scarcity caused scarcity, adding to the value of the dollar.

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The euro-basket of currencies fell from $1.25 in December 1996 to $1.15 by February. Aided by a March 1997 Fed rate hike to 5.5 percent, the dollar continued levitating, with the euro-basket falling to $1.05 by August 1997. Reflecting a dollar in increasingly short supply relative to the demand for it, gold fell from $369 per ounce in December 1996 to $319 by mid-1997 and $288 by year-end.

The 1996 warning on irrational exuberance created a major change in the liquidity environment. For exuberant companies and countries (some irrationally so), the drying up of liquidity was too intense. After borrowing dollars pre-1997, the dollar had become suddenly much more valuable, making repayment difficult. The Asia crisis hit in July 1997, with Thailand's devaluation, followed quickly by Malaysia, Korea and Indonesia, and in 1998 by Russia and Brazil. The dollar continued strengthening through 1998, a sign of scarcer liquidity. Credit spreads widened sharply for most corporate borrowers, eating into profits.

Much of Asia fell into a deep recession (though China held its dollar peg and slowed only to 7 percent in mid-1998). The U.S. saw overall corporate profits shrink in 1998, as high real interest rates and Asia's slowdown took their toll.

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Shrinking U.S. profits was a sign of recession in 1990 and 2001. But the 1997-98 swing away from liquidity and profitability was less onerous for U.S. growth (and for the stock prices of many multinationals). U.S. assets and liabilities were both in dollars, which remained the world's reserve currency. The strengthening dollar attracted global liquidity to the U.S., softening the impact of dollar scarcity. Japan had enjoyed much the same preferred status in the 1980s--yen strength had attracted global funds, driving Japan's late-'80s boom.

Of course, Japan's scarce-yen bubble ended badly in 1990. The long malaise has left Japanese equities still at a fraction of their 1990 high, whereas U.S. growth restarted in 2002, pushing broad equity indices to retest their all-time highs.

Two liquidity-related differences probably explain the contrast. First, the U.S. cut interest rates sharply enough after 9/11 that the dollar began weakening and the scarcity spiral was broken. In contrast, yen scarcity (measured by yen strength) persisted for more than a decade. Second, the U.S. provided a major reduction in the cost of capital through the 2003 tax cut on dividends and capital gains.

A third difference with Japan's '80s experience was the importance of the dollar and the U.S. to the global economy. Yen scarcity in the '80s and '90s mostly affected Japan, whereas dollar scarcity from 1997-2001 had a bigger effect outside the U.S. (though U.S. farmers and commodity producers felt the deflation pinch). The result has been a durable U.S. expansion strong enough to lift global growth to a new level.

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Looking Forward

Thus, the last decade has seen the liquidity environment pass through a unique swing--from disinflation to deflation to inflation. Dollar strength, dollar scarcity and the high real Fed funds rate caused a rippling global deflation crisis. Then dollar weakness and a negative real Fed funds rate provided a flood of liquidity, growth and profits.

The 21st century swing in liquidity has not been without cost. With a long lag, inflation moved inversely with the dollar, falling after it rose in the late '90s, and now rising after the dollar's value fell. This leaves inflation as the latest in the long series of liquidity-related challenges in the world of finance.

As 2007 approaches, we enjoy a world filled with liquidity but worry about inflation. U.S. corporate liquidity (financial assets minus debt) has reached $2 trillion. Private equity and venture capital funds are flush. Hedge funds stride the planet, wielding billions for new opportunities. For commodity producers, the liquidity contrast with the '80s and '90s is particularly sharp. Bankers search 24-7 for potential borrowers, whether small, big or, ideally, mega. The supply of lendable funds seems inexhaustible, despite the rate-hiking efforts at the Federal Reserve and the European Central Bank.

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Since 2001, the U.S. household sector has added nearly $3.7 trillion to its financial net worth (assets excluding homes and cars, less all debt). This shows up in record holdings of time deposits, life insurance, pension reserves, unincorporated businesses and, contrary to popular perceptions, relatively slow growth in credit card and auto debt.

The flood of liquidity is a global phenomenon, and welcome, in most cases. Japan and Europe are growing at their fastest pace in years, along with China and India. And, it's not only U.S. companies that have enjoyed the benefits of low real borrowing rates for dollars, but companies around the world.

Foreign central banks have built their dollar reserves to $4.6 trillion, in part to buffer the penetration of dollar liquidity into their own economies. By owning U.S. debt in lieu of their own government's debt, dollar-rich foreign central banks have pushed local interest rates up and U.S. interest rates down. For example, China and Brazil keep their local rates higher than U.S. rates by building dollar reserves. This pool of dollar liquidity at foreign central banks would act as a buffer in the opposite direction if that becomes appropriate, blunting the impact of a withdrawal of dollar liquidity.

The early-21st century challenge for global capital markets (and the corporate and household wealth that funds them) is the productive use of high levels of liquidity. It will take years to evaluate the profitability of the various destinations for this liquidity. Some of the positives seem clear--better infrastructure in developing countries, increased levels of R & D pointing to a wave of new inventions, the funding of small businesses and venture capital, the development of local-currency yield curves in Mexico, Brazil, China, Turkey and elsewhere, leading to consumer finance, and eventually, mortgages and more housing.

It's harder to evaluate possible excesses from plentiful liquidity--high rates of bond issuance related to tight credit spreads, the boom in commodity-producing investments counting on high commodity prices, China's buildup in fixed-asset investments and the surge in U.S. housing starts in 2005, to name a few.

In conclusion, liquidity has swung from the scarcity of the 1990s to the plentiful environment of recent years. Markets are humming along, investing and allocating the bounty. Governments are trying to regulate it and tax the profits, as governments do. Central banks are monitoring the liquidity and worrying about inflation. Importantly, inventors are busy tinkering. And living standards in many countries are rising faster than in recent decades. At least for now, the 21st century swing toward liquidity seems to be adding to long-term global growth and innovation and the financial challenges that go with them.

David R. Malpass ([e-mail]) has been Chief Economist for Bear Stearns & Co. Inc. in New York since 1993. He specializes in forecasting the U.S. economy, Washington analysis and global investment themes. He has held economic appointments at the U.S. Treasury and State Departments during the Reagan and first Bush administrations.

RELATED ARTICLE: Economic View from 1937

Excerpted below are sections from "Favorable and Retarding Factors for 1937 Listed by Economist," which appeared in the February 1937 issue of The Controller. The article is based on a presentation given by Donald B. Woodward, economist for Moody's Investor Services, to a meeting of the New England Control (or Chapter) of The Controllers Institute of America, held January 19, 1937.

"An economist must always take a running jump into any subject from history. This mental habit may be cynically called laziness, but a more friendly critic might agree that perspective can best be attained by establishing certain guide posts. In seeking some foresight of 1937, perspective is much needed.

We might say, very roughly, that the community is perhaps within 10 to 15 percent of being as well off as a decade or so ago, that near to being as well off as during what is considered a reasonably prosperous period .... measured against conditions four or five years ago, of course, business has improved vastly.

Where we are, then, is in that stage of the business cycle called recovery. Prosperity has not yet been generally attained, although certain companies and industries are already in that happy position.

A depression has occurred and painfully the business community is working its way uphill from the depths and is making quite substantial progress. But there is a crocodile on this otherwise familiar road--in fact, I think I can see at least two large ones.

The first [factor] is the international situation .... international relations have deteriorated almost steadily for some years and during the last year have gone from bad to still worse. The causes are partly economic, arising from depression sufferings, but in part they are the manifestation of grave social disturbance that has other roots as well.

There is, of course, some economic recovery in the world, but to a very large extent it results from desperate moves toward uneconomic self-sufficiency, motivated by the hideous fear of bombs and gas and starvation. To a large extent, too, it is due to the roaring machinery of munitions factories pressed every more urgently as the roaring machinery of a neighboring country's armament works are heard.

The United States has a heavy responsibility to bear. We have taken over such a position of the world's gold as to wreck monetary systems. We have refused to trade, being willing only to sell. We helped carve up Europe into an economic monstrosity and then poured in the drug of bad loans to help make the situation completely impossible. No, the situation is not hopeless. And another world war may not result, for there are many other alternatives.

Secondly, there is the domestic social situation, more commonly called the political situation.... The primary fact is that government has been ordered to regulate business, to create and perpetuate prosperity and to bring about a redistribution of income in favor of the so-called lower classes. The doctrines of laissez faire have, at least for the present, wasted their sweetness upon a very arid desert air.

I have real confidence in the domestic business outlook for 1937 and somewhat beyond .... three forces of signficance appear.

The first is that this country has an enormous unsatisfied demand for all manner of capital goods. The second is the monetary situation. Our financial and monetary system is pretty well back on its feet and is functioning in a way that facilitates economic operations.

The third factor is the armament race throughout nearly all of the world. The motivation is bad in every respect, and economically, as well as politically, the results may eventually be unfortunate. But for the present, it means a vast stimulation to production and output of many materials and the improvements in those lines spread inevitably to others.

On these three factors, therefore, we can build a forecast for 1937 which is favorable, which contemplates rising business activity. The new year should be better than the old and, as a guess, perhaps 10 to 15 percent better in the aggregate volume.

The final question of 1937 that needs our most careful attention is the broad subject of corporate policies. What is going to be the general character and direction of the attitude and decisions of the managers of this industrial system, which in the last half century or so has come to dominate the life of the United States?

First, will business and the new social demands manifested through governmental charges find a method of compatibility, or is a long and damaging struggle in prospect? Second, will corporate management fairly and openly meet labor, and through education, negotiation and cooperation prevent the development of harmful struggles?

Third, will corporate management follow a pricing policy which will wisely avoid both the evils of ruinously low prices and overly rigid price maintenance and boosting?

I am an optimist ... I think that American business will find a way, as it always has, and that perhaps with some false starts, there is a good chance that it will be the best way."

--Compiled by Ellen M. Heffes

RELATED ARTICLE: Corporate Cash Management: Historical Overview

Although companies have long recognized cash as a critically important asset, it wasn't until the 1950s that Wall Street began to offer corporate America formal cash management services.

From the '50s through the next four decades or so, the conventional approach to managing cash--the most basic form of liquidity--was through actively-traded portfolios. The primary objective was to seek maximum returns and, due to the associated tax benefits, preferred stocks generally were the instrument of choice.

During the '90s, the business of cash management began to take on a "new look." More specifically, several factors led to this shift in cash management philosophy.

The first of these factors dates to May 1993, when the Financial Accounting Standards Board No. 115 (FASB 115) accounting standards were adopted. These new standards significantly altered the accounting rules for treating certain securities and established three investment categories: held-to-maturity, trading and available-for-sale.

With the advent of FASB 115, it became increasingly common for companies to pursue buy and hold-to-maturity strategies in order to avoid the impact on profit-and-loss statements often associated with active trading. This evolution also led to the introduction of the first non-fee-based compensation programs.

Coincident with the introduction of FASB 115, the decade of the '90s also saw the rapid rise of the so-called "New Economy," which was fueled primarily by the booming technology sector. Companies willing to take risks often reaped extraordinary rewards, at least in the short term. Understanding, as they did, that their companies represented high-risk ventures, those responsible for managing the cash became increasingly risk-averse and more inclined to pursue accrual-based investment strategies.

At the turn of the century, the cash management industry embraced in earnest the Internet and its associated technological advantages. Among those advantages was the ability to deliver account documents and accounting data electronically. In addition, cash managers now had access to a broader range of securities, as well as the ability to implement transactions online.

The Sarbanes-Oxley Act of 2002 led to the development of new technologies that now make it possible to perform higher degrees of investment policy compliance monitoring and other portfolio monitoring functions. These software platforms afford all parties greater transparency and, therefore, accountability.

Recently, a number of cash managers have introduced "Money Market Portals," which enable companies to implement trades via the Internet. These portals represent a secure, highly efficient approach to all aspects of cash management, including third-party reporting.

Clearly, the cash management business has witnessed dramatic changes over the past 50 years, and there is little doubt that the industry will continue on its evolutionary path in response to legislative, economic and technological forces.

Richard Saperstein is a Senior Managing Director at Bear, Stearns & Co. Inc., where, as head of the Corporate Cash Management Group, he and his team oversee more than $10 billion in client assets. He can be reached at [e-mail] or 212.272.0800.

By Richard Saperstein