The European Sovereign Debt Crisis is a solvency crisis

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.

Liquidity and Solvency, May 2010

The European Debt Crisis is a solvency crisis. But when bankruptcy comes, it is normally the result of a liquidity crisis. Politicians dither and try to resist the inevitable, eventually creating panic and bailouts. At some point this approach either papers over losses at taxpayer expense or it fails catastrophically.

I have been saying for some time that the likely failure of policy makers to deal with the sovereign debt crisis will be the origins of the next crisis. But I am a eurosceptic. Of course I would say that. Shouldn’t you believe that my own cognitive biases are driving my conclusions?

Well, the political imperatives for the single currency are still operative. Moreover, I don’t see any way to force a euro zone dissolution now while we are near a double dip without creating yet another panic and cratering the global economy. So when I talk about the euro zone these days, despite my euroscepticism, I am not pushing an anti-Euro line. It is just the opposite; I am suggesting ways the euro zone can best remain intact despite the political and economic impediments.

It would easy for me to say something like, “see I told you so. The euro is an abomination and the peripherals should simply leave or be tossed out of the euro zone.” But how does that add any value? It’s easy to just throw your hands up and make gloomy predictions. However, this adds zero value.

We are in a crisis and what we need are workable solutions that reduce the potential for worst-case economic outcomes. A euro breakup increases them. So while I believe this is solvency crisis, I am saying that when you reach a panic stage, you have to deal with liquidity first.

Is it debatable whether Italy is solvent longer-term? Sure. That’s why Italy is under attack. But the right way to deal with this is to stop the panic and address the issues that could lead to longer-term insolvency. Remember, Italy has a primary surplus. It is high debt and interest costs plus slow growth which are Italy’s problems.

The point is EMU is a political construct and unworkable in its present state.  The question is whether the Europeans want to take the political steps like Eurobonds or fiscal integration that are necessary to support a stable currency union. There are many indications that Europeans do not.

If not, if they want an exit, the thing to do is to find a way to pay for the bailout of the various banking systems that would occur with an exit of Greece or Italy. I don’t see any way to do this now while we are near a double dip without triggering a panic and potential global depression. A better breakup solution is to provide enough liquidity and support enough growth so that the breakup can be done when economies and banks are healthier. In some ways, you could argue this is the German strategy right now.

Liquidity issues first, then solvency issues and/or breakup.

P.S. – just because some countries default, doesn’t mean the single currency must break apart. I still believe monetisation and default are more likely than breakup. However, the longer it takes to get this sorted, the higher the odds of a breakup.

  1. J. Michael Dunn says

    Have you seen Michael Lewis'(the Big short,etc.)article in the current vanity Fair(J-Lo on the cover)on How Germany owns Europe,Edward?

    1. David Lazarus says

      Hardly. Their banks are practically insolvent. All these sovereign bailouts have been to bail out the core banks. That is why France is now suffering an increase in its CDS spreads as default looks increasingly likely. Also the asset stripping of one nation by another will end very badly.

  2. Edward Harrison says

    I have it bookmarked to read. I saw that felix Salmon panned the article as excessively leaning on stereotypes to tell the story Lewis wanted to tell. I look forward to reading it though.

  3. Dave Holden says

    I wonder what would be more disruptive – Italy etc leaving or Germany leaving.

    Of course your right fix the panic then address the issue, the problem is of course the Eurocracy rarely addresses anything without the incentive of a crisis.

  4. James says

    Ok here’s the question, lets say we restructure greece and portugal. They are still running a 10% of GDP trade deficit with the rest of the eurozone. Someone is going to have to finance that deficit, if its not the market then who?? The problem is that they have structurally uncompetitive economies and no amount of debt forgiveness is going to change this fact. If they decide that they want to go the route of becoming competitive economies it is going to take about a decade of flat/declining real wage growth which is very difficult given private sector balance sheets. It seems to me they would be better off leaving the eurozone, default/restructuring on existing debt, and using competitive devaluation to soften the blow as public and private sectors repair their balance sheets.

  5. Tom Hickey says

    Extend and pretend, kicking the can down the road, hoping for the best. All it will take is a good shock — a Credit Anstalt moment — for the house of cards to come tumbling down. With the global economy rolling over, hope is not looking good.

  6. NOTaREALmerican says

    Re: A better breakup solution is to provide enough liquidity and support enough growth so that the breakup can be done when economies and banks are healthier.

    Unfortunately, that sentence is the Keynesian catch-22 that can’t be overcome by any government. When times are “healthy” human “logic” will “conclude” the future will be “healthy” forever (so, why bother worrying about past problems, let’s PAR-TAY!!!).

    Collapse is inevitable (not saying it’s the solution, just saying it’s the only path possible).

    1. Edward Harrison says

      Nonsense. Felix Zulauf is saying the same thing:

      And he’s no more Keynesian than I am.

      1. NOTaREALmerican says

        I’m not disagreeing that “providing liquidity” keeps the system going. I just saying the “keeping the system going” guarantees that “the problem” (solvency) won’t be fixed.

        “The problem” isn’t JUST solvency. The problem is also WHO loses when insolvency is “fixed”. “Providing liquidity” allows those who are the most insolvent to pretend not-to-be.

        So… “Providing liquidity” keeps the bankrupt society running – which keeps the morally bankrupt people running the society in power – which allows them to NOT fix “the problem” (insolvency) which they (the morally bankrupt) caused in the first place because “fixing the problem” would cause harm to themselves (the morally bankrupt).

        Therefore, the only path a morally bankrupt society has leads to collapse.

        1. David Lazarus says

          Don’t forget that the German banks would also become insolvent when the losses return to Germany. The big lie is dumping losses on taxpayers. That is why I am against them. It steals governments ammunition for stimulating the economy.

  7. PBlacque says

    I agree that liquidity buys a few months or maybe one or two years in the hope that we can all fix things on the upswing. But no one has provided cogent arguments as to how this “upswing” will be triggered and sustained in today’s world.

    And so how is this “kicking the liquid can” any different from all we’ve tried here in the US with little success? Your and Zulauf’s argument sound exactly like the rationale for TARP back in 2008… “if not liquidity now, then hell tomorrow!” I agree, better to survive if only to fight another day.

    But who is leading with ideas here? Let alone leadership a la FDR…

    It seems we’re in that great gunfighters final duel scene from “The Good the Bad and the Ugly”. All of us eyeing each other’s next move either to preempt the first to pull the trigger or to let the others kill each other…

    Somehow, I think Germany and France are simply trying to prolong the pain simply because they know they can easily get killed here but neither wants to make a brash move which will weaken it even further… and which might prove to be unecessary in the near/medium term.


Comments are closed.

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More