A couple of days, in Is the real reason behind the Shanghai rout due to something else?, we said we were prepared to be proven wrong on our hunch. Today, we admit that our hunch is most likely wrong as we learnt from another interview on Marc Faber, who further explained his prediction on the coming correction in an earlier interview in January (see Video of Marc Faber?s interview at Bloomberg). Before we elaborate on why liquidity is going to tighten over the months, let us recap on some concepts…

First, what drives current global asset prices? Traditionally, it is the valuation of the asset (which among other things, depended on its future earnings) that drives its price. As we mentioned before in Have we escaped from the dangers of inflation?, the global spigot of liquidity (see Liquidity?Global Markets Face `Severe Correction,? Faber Says on the concept of ?liquidity?) drives asset prices. Thus, it displaces valuation as the primary driver of asset prices.

Next, how is liquidity created? Traditionally, the money that is ?printed? by the central bank is the source of liquidity. But today, through the fractional reserve banking system (see 363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy? on how money and credit is created by the banks), the central bank is no longer in total control of liquidity because the creation of money and money substitutes is no longer in its hands. This situation has gone to the point whereby money substitutes (e.g. derivatives, securitised loans) supplanted the ?original? money created by the central bank as the vast bulk of global liquidity (see Prepare for asset repricing, warns Trichet on the extent of this supplantation). The problem with using money substitutes as liquidity is that its value is dependent on the imputed values of asset prices. That is, if for some reason, should its underlying asset price collapse, the money substitute?s value will ?disappear.?

Now, what if global asset prices are mainly driven by the quantity of liquidity, which in turn is largely made up of money substitutes that is outside the control of the central bank? We can see that in such an arrangement, global asset prices are highly vulnerable to deflation (see Spectre of deflation). Furthermore, Marc Faber observed that higher asset prices spawn higher liquidity (the converse is also true).

Finally, what can trigger the contraction of money substitutes (i.e. a contraction in liquidity) which in turn will trigger a deflation of asset prices (i.e. seen as a ?correction? in the markets)? We will answer this question in the next article.