Edited by Kern Alexander and Rahul Dhumale
Chapter 15: Liquidity Illusions in the Global Financial Architecture
Anastasia Nesvetailova Editors’ abstract: Dr Anastasia Nesvetailova analyses the illusion of liquidity and argues that illusionary liquidity phenomena are increasingly a central trigger of financial crises. These illusions lead investors to underestimate risk during periods of economic optimism in the belief that their investments are safe and liquid. Just as most investors begin to share this sense of optimism markets can however move sharply against them by becoming illiquid. This can result in credit lines being closed with substantial losses and systemic contagion potentially moving across markets. She discusses the problem of liquidity illusions and the dynamic interplay between the processes of financial deregulation and innovation and subjective factors such as confidence and expectations and how they affect investors’ perceptions and the impact on financial stability. INTRODUCTION In the summer of 2007, a contagious liquidity meltdown hit the world markets. Sparked by the subprime mortgage fiasco in the USA, financial panic and tumbling asset values did not only destabilise the American financial system, but have also shaken the European and Asian markets. The crisis prompted unprecedented emergency measures by the central banks in the USA, Japan, EU and later Canada, Australia and the UK: in only a few days in mid-August, the world’s central banks had injected more than $240 billion into the markets; in the USA, the Federal Reserve cut the discount rate by half a per cent to 5.75 per cent from 6.25 per cent. At the time of writing in 2012, the turbulence in financial markets seems...
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