Liquidity and Solvency

When bankruptcy comes, it does so normally as a result of a liquidity crisis. This is true for countries as much as it is for companies. It’s not as if someone in charge walks in one day and says "you are insolvent so you must default immediately." That is what happens in the case of banks seized by the regulator.

In other cases of insolvency, creditors become spooked about longer-term insolvency. At first, they demand a higher return for their loans. Eventually, they pull in their horns altogether. Liquidity dries up and the company or country is unable to roll over its debt requirements. It literally runs out of money.

This is exactly what happened to Northern Rock, Bear Stearns and Lehman Brothers in 2007 and 2008. They ran out of money because no one was willing to lend to them – quite different from the bank seizures we see the FDIC conducting every Friday.

The problem, of course, in a financial crisis is that everyone is panicked and eyeing everyone else warily. Solvent companies can be taken down in the crisis too. I explained this in my post titled simply "Solvency" in the week just prior to Lehman’s collapse.

When it comes to solvency it is usually an issue of cash flow and not profitability. An institution can be perfectly profitable and become insolvent, just as an unprofitable institution like General Motors (with over $50 billion negative equity – see their Q2 2008 balance sheet) can continue as a going concern.

One problem with financial crises is that perfectly healthy companies, perfectly healthy financial institutions can go bankrupt just because they temporarily lack the funds to pay their creditors. This is what the lack of liquidity in our financial system can do. The real problem of crisis is that healthy institutions are often dragged down with unhealthy ones, leading to a dead weight loss and a negative feedback loop in the real economy.

And as I explained in a companion piece the next month when the Federal Reserve was adding liquidity to all manner of financial markets, that’s what deflationary spirals are all about. The Federal Reserve acts as a lender of last resort to prevent a collapse of the financial system and solvent companies due to a lack of credit:

The thing we want to avoid is solid, well-run businesses being forced into bankruptcy because no one will lend to them or because they can not roll over their debt. Certainly, one might feel well-run companies should not get into a position where they are beholden to their lenders for survival. Fair point, but it is still clear that there are companies which would be able to operate normally under normal credit conditions, which are suffering in these credit conditions. That is a dead-weight loss to the economy and is what ultimately leads to the vicious spiral of deflation.

So when I think about Greece and their woes, I think a lot about liquidity, not just solvency. Paul Krugman had an interesting post out today called "We’re not Greece" outlining how the US and Greece differ. He mentioned some pretty important facts like "we have a much lower level of debt" and "we have a clear path to economic recovery, while Greece doesn’t."

The thing I was waiting for Krugman to say, which he didn’t say is that Greece is a user of currency and the US is not. That is an important distinction when thinking about financial crises that hinge mostly on liquidity concerns.  The problem for Greece has been that it is the user of currency and not the creator. It’s not like Greece could have gone to its backyard to pick some Drachmas off its money tree because it issues debt in Euros. So when push came to shove and worries mounted about Greece’s fiscal condition, Greece had to demonstrate it can meet its obligations like any other user of currency — or lose the faith of investors and default. Greece could literally run out of money just like Northern Rock, Bear Stearns and Lehman Brothers. It’s as simple as that.

For creators of currency like the US, the UK or Canada, for example, these liquidity concerns just aren’t there. Putting aside people’s very real objections to the Federal Reserve buying up US government debt, the fact is the US cannot involuntarily face a liquidity crisis. The US government can always meet its obligations to pay with more dollars that only it can create. America’s fiscal questions are all long-term in nature (as are the associated questions of resource allocation and inflation). Greece’s fiscal woes are not. That is a very important distinction when the financial world is in crisis.