System Liquidity Risk – Cash Is Preferred & Appreciated

There is quite a bit of debate right now about whether inflation’s effects will worsen again soon; or, whether the inflation threat has been minimized and “disinflation” will prevail. Don’t look now, but the specter of a liquidity crisis is looming in the background.

The situation is such that a liquidity crisis of epic proportions might overtake all of us in our arguments about the quantity and extent of inflation’s effects. My concern was heightened this past weekend when I drove to a small, local restaurant to pick up a take-out order.

The proprietor, who is also the cook, and the cashier, indicated that he would be back out with my order shortly. Nobody else was in the restaurant at the time. Some others came in and asked how long I had been waiting. I told them I was there for pick-up and that dining in was not an option. I pointed to the sign which said that take-out only was available on Sundays and holidays due to a staff shortage.

It was then that I noticed a sign which covered the front of the cash register. It said, “Cash Is Preferred and Appreciated”. I mused about that for awhile. Twenty minutes later, well-beyond the time my order was scheduled for pickup, I pulled out my bank card to pay for my order. The proprietor, who did not speak my language, tapped the sign. I was somewhat befuddled and presented my card again. He tapped the sign again.

Somewhat frustrated, I said that I did not have any cash with me (I didn’t). He took my card and completed the transaction.

Looking Back – Other Signs? 

As I think back over the past few years, there have been other indications of growing system liquidity risk. I think it quite likely, that at some point in the future, the date of March 26, 2020 will be given the attention it deserves. That is the day the Federal Reserve eliminated reserve requirements for “all depository institutions”.

If you are not familiar with fractional-reserve banking, you might want to read my article Fractional-Reserve Banking – The Elephant In The Room. It was published six months after the elimination of fractional-reserve requirements. At the time I wrote the article, I was not aware then that the reserve requirements had been eliminated. Previous to that, the reserve requirement was 10%, an abysmally low level in its own right; but, marginally indicative of a small measure of financial prudence. Apparently, even holding reserves of such a meager amount was too big of a burden for the banks.

For certain, the reserve requirement did not keep banks from getting into trouble. Last year’s headline failures of Silicon Valley Bank, Signature Bank, and First Republic Bank confirmed that, even without a reserve requirement, banks continue to dig deeper holes for themselves.

The removal of fractional-reserve requirements is “official” acknowledgement that the banking system is totally insolvent and illiquid.

A few years ago, concern about liquidity and creditworthiness in the overnight money markets sent respective interest rates wildly seesawing between what might be considered a relatively normal level on the low side and triple digits on the high side. Sometimes, the money wasn’t available at any rate.

More recently, we hear about the huge losses being incurred by holders of loans backed by commercial real estate. What is happening in commercial real estate now is not unlike what happened in the residential housing market in 2008.

Another problem sign is the move to deemphasize the use of cash. This, of course, conflicts with my example at the beginning of this article.

What Should You Do? 

There is not much you can do. The system is what it is and it is bigger than all of us. However, there are some precautions that might be helpful.

First, lessen your dependency on eternally higher asset prices. The more you need to see stocks, real estate, gold, etc. go higher in price to compensate for high levels of debt and current expenses, the more vulnerable you are personally to a liquidity crisis.

Second, lower your use of credit to finance everything. Inflation doesn’t last forever and the expectation of always paying back with cheaper dollars is questionable. (see End To Inflation – Three Possibilities)

Finally, keep some cash on hand. You cannot predict and navigate the timing of bank failures, new regulations, emergency situations, etc.