The too much liquidity (credit bubble) pitfall - lessons from past financial crises

So when the NASDAQ blew up in 2000 - 2001, combined with 9/11, we saw the Fed step on the gas, flooding the world with excess capital in order to restimulate the economy. Not a bad idea. The bad idea was keeping the foot to the pedal too long. And now we'll pay the price. Big time.

Excess leads to pullback. And the mother of all credit bubbles, where so many individual investors are not only involved in the asset bubble, but also leveraged to the hilt, well, the world has never seen anything like this credit orgy.

And the world will never see what they're about to see again. Thank god.

THE spectacular Wall Street crash of Black Monday, October 19, 1987, saw equity prices record their biggest one-day fall since the Great Depression. The experience was a memorable, if unhappy, one for investors at the time.

But looking back there is something else about the crash that is both interesting and important. It might have been the world's first modern financial crisis.

The Fed has responded to these modern financial crises by quickly pumping out liquidity, by reassuring market players of its readiness to intervene to prevent market failure and by knocking heads together where necessary.

The Fed's aim was to stop a fire sale of assets, and credit problems cascading through the financial system, leading to the failure of financial institutions, systemic problems and economic recession. Nobody could sensibly object to that.

The problem, which Kohn only obliquely acknowledges, is that the Fed left too much money in the system for too long and kept interest rates too low.

Financial markets recovered quickly, but too much liquidity led to price and other pressures, rising interest rates and asset price falls and recession. This is a lesson that needs to be absorbed.

Investors and the financial institutions which manage their money and their risk need to remember that while central banks will act to stop a financial crisis leading to systemic damage, it isn't their business to protect individual investors or financial institutions from serious losses.