Friday, 11 May 2012

Liquidity or solvency problem?

It's rarely discussed in the media, but at the heart of the crisis in government borrowing is one question: is this a liquidity crisis or a solvency crisis?

You can't understand the problem without understanding that question. I think the media avoid it because it seems technical, and perhaps the people in the media don't understand it themselves, but the technical-sounding terms hide two very simple concepts which I shall now explain.

Scenario 1. You are on a night out but you've lost your wallet leaving you unable to pay for your taxi home. You have money in the bank, but at this precise moment you have no way of using it to pay the taxi driver. You have a liquidity problem: you have money but temporarily can't get to it.

Scenario 2. Your owe money, the bills are piling up, you have no savings, no assets to sell and therefore no realistic chance of paying those bills. Even if You borrowed money to cover the shortfall you are only delaying the inevitable. You have a solvency problem: you have run out of money.

In the beginning, the debt crisis was seen as a liquidity problem: struggling banks and countries were good for the money, but they needed a little help to get though a temporary tight patch. Rich countries agreed to lend them money to tide them over, on the assumption that they would get all the money back, plus interest. Everyone's a winner.

Over time the problem grew and people started to wonder whether this really was just a liquidity problem: could it be a solvency problem after all? Is it possible that the money may not be repaid? That is the stomach-churning thought that led the bond markets to flee at-risk countries and raise the interest rates of many others. Who wants to lend money to someone if they cannot pay it back? Is it even ethical to do so? As each successive bailout failed to solve the liquidity problem it was aimed at, the concern that this was really a solvency problem grew stronger.

But if the distinction is so simple, how could so many smart people confuse them? To see how it can be difficult in practice to distinguish the two, imagine scenario 3. It's 5 days until pay day, you are owed your wages by a reliable employer but you've had a difficult month with car repairs, have run out of money and need to borrow a few quid to buy food. This looks like a liquidity problem: in 5 days you will receive your salary, repay the loan and all will be well. A friend, relative or pay day loan company might well decide to lend you the money, confidently expecting to see it repaid.

But what if you return again with the same story the following month? And then the month after that? Your temporary difficulty, your exceptional expenditure, starts to look less exceptional and your financial difficulty seems less like a lack of liquidity and more like a flat-out lack of money: insolvency. Suddenly people start calculating that if they lend you money that'll be the last they see of it, and if you're going to go bankrupt it's better that you don't take their money down with you. But what if you really are just having a terrible run of luck and with help you will thrive and repay? If so, your creditors may be cutting you adrift and, if you're a country, creating enormous problems which could be avoided. That is the dilemma.

The dilemma is obscured in the maelstrom of daily discussion about other things: should you try to kick your expensive smoking habit? Pack in your gym membership and cable TV? Find ways to earn more money? Break away from a disastrous currency union which is preventing you from using monetary policy to ease the pressure on fiscal policy? But your overall strategy must always be guided by whether you are solvent but illiquid and therefore in need of bridging finance, or insolvent and destined for bankruptcy, in which case you may be better to grit your teeth and get on with it.

Specifically with Greece, it has now "restructured" some of its debt, which is the euphemism for telling its creditors that it is insolvent and making an agreement to repay a lower amount on extended terms. But most of the debt that remains is not owed to banks, who were strong-armed into agreeing to a restructuring, but to fellow European countries who lent money when Greece was already in difficulty with specific assurances that they would definitely be repaid. This borrowing was not "restructured" alongside the commercial loans, because doing so was considered politically impossible. I think it is also economically inevitable. Just one more part of the Euro problem in which political ambition will eventually be smashed on the unyielding rocks of economic arithmetic.

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