The Debt Crisis: It Ain’t Over Until It’s Over!

The people in charge, both in the United States and Europe, still believe that the problem we are facing is a liquidity problem. They, therefore, continue to come up with plans that “kick the can down the road a little further” but fail to come up with any solutions that will allow us to move on into the future.

For three years now, I have been arguing that the problem is not a liquidity problem but a solvency problem.

There is too much debt outstanding in the world! People, businesses, and governments cannot carry this debt much further, their debt load is unsustainable.

This is a solvency problem.

Liquidity problems are short-lived problems. They have to do with the ability of an asset holder to sell assets into the market place at prices that are near to the value of the assets on the balance sheet of the asset holder.

Liquidity problems arise because the two sides of a market have different information sets. The sellers of assets have a different set of information than do the buyers. Because of this, the buyers generally take a little vacation until they have more information about the asset prices and regain sufficient confidence in the amount of information they have to begin trading again. At this time the liquidity problem goes away.

Central banks (and other government agencies) may intervene in the market providing a floor to asset prices until such time as the buyers start buying again. This is the “classic” function of the central banks to provide liquidity to the banking system.

Solvency problems are different. When solvency problems occur, the holders of assets know that the value of their assets are below that recorded on their balance sheets. They are reluctant to sell the assets or recognize the value of the assets because any write down of the value of the assets would have to be taken against net worth and this might threaten the solvency of the economic unit that holds the underwater asset.

A solvency problem is a “sell” side problem whereas a liquidity problem is a “buy” side problem.

Economic growth or price inflation may help asset prices regain their balance sheet value. However, in the absence of either of these forces, market prices may remain below the book value of the asset and this threatens the existence of the household, business, or government.

There is too much debt outstanding in the world! Whoops, I said that before?

Much of the debt is underwater. Economic growth or inflation are not coming along fast enough or strong enough to “buy out” this underwater situation. Hence, the threat of insolvency exists for many people, businesses, or governments.

Sooner or later asset values are going to have to be written down!

Continuing to postpone the day when they are going to be recognized just creates more and more uncertainty.

The fact that the people running the governments in America and Europe can’t come to grips with this just creates even more uncertainty.

This uncertainty is the biggest factor in the marketplace right now. With so much uncertainty in the world, market participants jump this way and that way in response to almost any new bit of information being released.

And, my guess is that this volatility will continue until people recognize the nature of the problem they are facing. Until the people running things accept the fact that the crisis they are facing is a solvency crisis and do something about it, this uncertainty and volatility will just increase.

As Yogi Berra said, “It ain’t over ‘til it’s over.”

Until people realize it is a solvency problem and propose solutions to “get it over with”, the situation will continue.

Now we know what it is like to live in a world without leaders!

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