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.