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.

• Author: Malpass, David R.
• Position: FEI@75

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...