Financial Stability Ch 23: The Water Balloon Theory of Global Finance
Book: Financial Stability: Fraud, Confidence and the Wealth of Nations
Authors: Frederick L. Feldkamp and R. Christopher Whalen
ISBN: 978-1-118-93579-8
Chapter 23 gives the book its most memorable image. Think of global finance as a water balloon. Earth’s total capital and liquidity sit inside the skin. Push on one spot and another spot bulges. If you push and nothing moves, or the reaction looks wrong, something hidden is going on underneath.
Every crisis starts with fake liquidity
Before every financial crisis in history, investors convinced themselves that vast new liquidity appeared without cost. Sometimes ignorance, sometimes deceit. Before 2007-2009, even serious experts like Alan Greenspan grew complacent while the world inflated a $67 trillion bubble through fraudulent off-balance sheet liabilities and shadow banking.
When credit spreads sit at equilibrium near the complete-market range (Charts 9.1, 9.2, and 9.3) with no logical explanation, assume systemic fraud until proven otherwise. A level playing field means entities with no government support actively and transparently arbitrage risk-free securities to hold equilibrium. Without that, low spreads are a warning light, not a victory lap.
Daily correction beats periodic panic
Track spread changes daily and correlate them with events, and you eventually get a policy feedback loop that fixes mistakes before they become catastrophes. Successful businesses run statistical process control every day. Finance mostly waits for quarterly earnings and annual stress tests. The authors think that is backwards.
Folly is the enemy. Barbara Tuchman called it woodenheadedness: an inability to adapt because change feels threatening. That is what blocked U.S. leaders from listening to Bernanke and Kohn until investors nearly abandoned all domestic risk in 2008.
The cost of waiting
In 2008, voters replaced leaders who turned a $4 trillion annual wealth expansion into a $17 trillion annual contraction. Even the holdouts changed course eventually. By then, about $14 trillion of a $21 trillion annual damage path had already happened. The remaining risk toward a $67 trillion potential loss was already in motion.
The good news: it is never too late to change course. Compound interest always imposes a delay cost, but ending folly is what starts recovery. The Dutch tulip bust took seven years and debt forgiveness before affected groups returned to private risk. The 2008 recovery was faster than any prior systemic debt-contraction deflation in history.
What Congress still has to do
What remains in the U.S. is largely a legislative problem. The Constitution gives Congress exclusive power over uniform bankruptcy law, infrastructure, tax policy, immigration, and human rights advances. No king can decree mortgage forgiveness here.
Feldkamp and Whalen want mortgage forgiveness and document reconciliation, new infrastructure, health care reform, smarter tax policy, financial system fixes, and immigration policy that grows the productive base. All of it needs responsible limits on unproductive speculation. Productive borrowing and spending should face no cap because it generates more revenue than it costs.
Managed properly, the water balloon has no size limit. Humanity can fund whatever productive investment it needs. The path is clear. The open question is whether we can overcome evil and folly long enough to walk it.
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Next: Financial Stability Ch 24: Why Stable Markets Are Mathematically Unstable