Liquidity and confidence.

It is popular these days to fret publicly about the ocean of liquidity now swirling around global financial markets. Morgan Stanley economist Stephen Roach, featured prominently in a recent Barron's magazine article, has stressed that "this liquidity-driven era of excesses and imbalances could well go down in history as a huge failure for modern-day central banking." Left unsaid, of course, is that Roach has sounded like a broken record on the disaster theme for many years.

The future of the world economy may well depend, nevertheless, on how policymakers come to terms with the liquidity issue. Is today's ample liquidity merely some awful trick by greedy, leveraging financial wizards looking to achieve short-term financial gain before they abruptly cut and run, leaving the naive central bankers to clean up the mess? Or does the liquidity reflect true growing value in the global economy?

Traditional economists define an asset's liquidity in terms of its ability to be transformed into another asset without loss of value. This notion of "money" is less than satisfying. Liquidity represents more than just a summing up of asset values. During the Asian and Russian financial crises in 1997-98, for instance, global liquidity dried up overnight, a frightening scenario as the high-yield corporate and emerging market bonds collapsed. When pared down to its essence, it may be that liquidity, when all is said and done, is nothing more than confidence. Federal Reserve Governor Kevin Warsh in a recent speech made this case: "When the [highly negative] outcomes are either highly improbable or, at the very least, subject to reasonably precise measurement, the conditions are ripe for liquidity to be plentiful."

Will today's wealth of liquidity soon dry up? It all depends on the level of confidence in the global capitalist model. It depends on the confidence in the ability of globalization to deliver economically. The United States is particularly crucial in that regard because the rest of the world is likely to follow in America's footsteps. There are a number of unknowns and by far the most crucial is whether U.S. politicians allow the American economic and financial systems to slip progressively into a protectionist mode. Thus, the answer to the liquidity question may well depend on the global commitment to liberalized financial markets and free trade, beginning with the United States.

Yet nothing about the future will be simple. We are living in an amazing globalized system where, with the exception of nations that export commodities (Russia and the other oil producers), the global economy is increasingly beyond the control of governments. Even China (or perhaps especially China) cannot be controlled.

In this brave new world, the role of governmental units is at best overrated. Only several years ago, institutions such as the World Bank, the International Monetary Fund, and the Paris Club played central and vital roles in the international capital and credit system. With many emerging markets now paying off debt, these governmental institutions are scrambling to seek some new mission (see "Is the IMF Obsolete?" on page 9). They had better hurry. The Chinese and the Indian governments are already moving throughout the emerging markets handing out cheap (subsidized) loans tied to bilateral agreements involving the exchange of commodities. Essentially, the Chinese, Indians, and others are underbidding the World Bank--and, unlike the World Bank, their loans involve no environmental or human rights standards.

If you do not believe that the international landscape has radically changed--that China, India, and the others buying up the world's commodities represents a potential death knell to the relevance of the international institutions--consider what happened in Washington the weekend of April 14, 2007. The industrialized nations held their semi-annual IMF/World Bank/G7 meeting of finance ministers and central bankers. The Chinese never bothered to show. China, with its trillion-dollar insurance policy in the form of central bank reserves, views itself as in the international system, but not a part of it, a view increasingly shared among many Asian nations.

Today the world is experiencing not just globalization, but a new sequence of globalization. The first stage involved direct foreign investment from the developed world into emerging markets. Now we are entering a new stage--the return of that capital to the industrialized economies. The emerging markets, led by China and India, are about to adopt the Singapore model of capital recycling--keeping the majority of their reserves liquid to continue purchasing developed world government bonds, but also planning for purchases of real tangible assets in the developed world.

How the industrialized world's politicians respond to this new form of capital recycling will be telling. The French have already stated that "strategic industries" cannot be owned by foreigners. And what company was recently designated a "hands-off" industry? The Dannon Company, makers of yogurt. Consider the U.S. actions against the foreign takeover of Unocal and the effort by Dubai Ports World to take over the administration of several U.S. ports. China itself is now expanding the number of assets considered untouchable for "economic security" reasons or as "key industries" or popular trademarks. A European investment banking friend of mine perhaps put it best: "The joke among European politicians is that foreign direct investment is fine, provided it is not from Russia, China, India, or the Arab countries. The rest is fine." In other words, foreign direct investment is acceptable as long as it is not from the people who have all the money. How the newly monied emerging market economies respond politically to such treatment remains to be seen.

The fact is that in a globalized world, where capital flows are making up for imbalances, it is automatically assumed by financial markets that capital flows freely. If this environment changes through government intervention, the potential for a global herd effect is enormous. Global money managers talk to each other. In the new world of dominant global markets, just a whiff that an economy is turning protectionist is deadly business. In the financial world, pessimism can be highly contagious. Want to see global liquidity dry up overnight? Let America turn protectionist. The rest of the world would soon follow.

None of this is to overlook the need for the major global economies, including the United States, to confront today's troubling imbalances. China's artificially weak currency is, in particular, hardly in China's best long-term economic interest. Yet it is not difficult to see that a change in the current policy mix for now remains a low probability. That means that world policymakers have no choice but to muddle through, with the primary goal being to keep the liberalized financial markets of free-flowing capital running as smoothly as possible until the Chinese political situation becomes more clear. At the end of the day, the issue is to maintain liquidity. The issue is confidence.