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« Top Headline Comments 7-23-11 | Main | Mad UK Scientist Open Thread. [krakatoa] »
July 23, 2011

Economics at AoSHQ U: Illiquidity vs Insolvency

(Ace mentioned this piece in his post on the Greek default yesterday.)

Here are other entries in the "Economics at AoSHQ U" series:

What is an economy?
What is money?

Given the confusing stories coming out of the press regarding the debt-ceiling debate, I thought it might be helpful to clear up one area where even veteran financial reporters and politicians confuse things: the difference between a liquidity problem and a solvency problem.

There are two ways to be out of money.

One way is to have a lack of cash to meet an immediate payment or bill or debt-service. This is a common consumer problem, especially among the more hard-up among us: the rent is due on Friday, but I don’t get paid until the end of the month. I have the income to cover the obligation, but I don’t have it at the moment the payment is due. In financial terms, this is a “liquidity crisis”.

An asset that can be quickly converted into cash is considered to be highly “liquid”, whereas an asset that cannot be quickly converted is “illiquid”. "Liquidity" for practical purposes is a synonym for "cash" (or other readily-transferable assets).

For example, let's say I have an original letter from Robert E. Lee to Jefferson Davis that I found in the bottom of a trunk. It's worth a lot of money, but no one knows exactly how much, or who exactly would buy it. It's a highly illiquid asset, even though it is a valuable asset. The same is true for real-estate, art, antiques, or other kinds of valuables. I’m broke in fact even though I might be a millionaire in theory and on paper. But I know I can sell my dirt-bike to Chet next door or pawn my guitar for a couple hundred bucks and then pay my rent -- my dirt-bike and guitar are more "liquid" than the letter from Robert E. Lee, even though the letter is worth considerably more in absolute terms. (Liquidity can also change over time -- if Chet already bought a dirt-bike from someone else and there is no other market for a used dirt-bike, my liquid asset has suddenly become illiquid.)

I could take out a loan against my Civil War-era letter (thus collateralizing it) rather than selling it outright, but this would also take a lot of time because the true value of the letter would have to be established first.

Another way to be out of money is to have obligations -- debt, payments, fees, and expenses -- that outstrip my ability to pay them from my income. Let’s say that I earn $2000 per month working as a janitor. I like to live the high life, however, and my monthly obligations -- rent, utilities, food, clothes, car payment, gas, insurance, gold chains, cover-charge at the clubs, and so on -- comes to $3000. In order to make up the difference between what I earn and what I owe, I’ve taken cash-advances from a credit card every month until my credit-line was maxed-out. Due to my parlous financial state, I can only afford to pay debt-service (the interest rate payment alone, with no money going towards the principal), and even that becomes a burden as the debt continues to inexorably grow. At that point, I am left with two options: reduce my expenses, or find a job that pays more money (increase my income). If I can find enough new income to pay down my debt and continue my style of life, all is well (unless I once again outspend my income, in which case I’m right back where I started). But let’s say that due to the poor job market and a lack of skills on my part, the janitor job is the best gig I can get. Given my income, I cannot ever hope to pay back my debt. I have cash in my pocket and other liquid assets like my gold chains, but not nearly enough to meet my obligations. In fact, given my prospects, I will never have enough to pay my debts. I am insolvent. “Insolvent” is just another way of saying “bankrupt”.

In terms of personal finance, a liquidity crisis is usually easily manageable via things like bridge loans (visiting the friendly neighborhood loan-shark), sale of assets (yard sale), or extension of terms (convincing your landlady to wait a week for the rent). A solvency problem is much more difficult -- sometimes impossible -- to fix. There are only two ways out of the solvency trap: raise income, or lower expenses. Sometimes you must do both. There’s no other way.

The same principles that govern personal finance also govern sovereign finance. The problem is that too many people see a liquidity problem with sovereign debt when what we really have is a solvency problem. Greece is the best current example of a state that is insolvent: it has a debt-to-income ratio of about 150%, and no prospects for substantially raising their income via taxes or fees. So: they are bankrupt. An individual in this position would probably declare a legal status of bankruptcy to discharge his debts to creditors and “start fresh” (albeit with a heavy hit to his credit rating). A sovereign nation goes into a state of “default”, which means that holders of their sovereign bonds (many of them foreigners) must take a “haircut” on the value of the bonds they hold -- sometimes all the way to 100%.

It’s important to note, though, that terms like “bankruptcy” and “default” are legalisms. They are not states of nature. Insolvency, however, is a state of nature -- essentially, you have drawn more out of a given system than you have put in, and thus have accrued an energy deficit that must be rectified (since all energy must be conserved). It really boils down to a matter of physics. In a world of scarce resources, “insolvency” is usually a recipe for disaster. In most of human history insolvency usually led to penury, starvation, destruction of the family, debtor’s prison, or even a death sentence. For sovereigns, it meant social collapse, hardship, famine, and sometimes conquest by a foreign power. Nature will conserve the energy lost, in one way or another. Balance will be restored.

Insolvency is a much worse problem than illiquidity (though a liquidity crisis can often lead to a solvency crisis).

On an individual basis, staying solvent is a simple matter: don’t overspend. Live within your means. Easier said than done, human nature being what it is, but there is no other way. Opportunities to increase your income dramatically are limited (you can’t count on the lottery), so managing your spending is usually the only route to solvency. This much is common sense to most people.

But the kicker is this: the same thing is true for sovereigns. Every sovereign that is in danger of default right now (including the United States) got that way due to overspending, not because of insufficient revenue. And the prime driver of spending in this modern age is the so-called “welfare state” -- government-provided pensions, healthcare, and subsidies.

Sovereigns are learning an uncomfortable truth about how to avoid insolvency: limit the welfare state. It is good and necessary for a sovereign to look after the most weak and helpless and downtrodden among its citizens; it is both the civilized and the moral thing to do. But when the ranks of victims expands to encompass one-third to one-half of the entire population, something has gone badly wrong and disaster cannot be far away. Kindness is a moral virtue, but it becomes a positive evil when it threatens to collapse the state itself. “Kindness” that leads to insolvency is not kindness at all, because it brings much suffering and sorrow in its wake.

“Civilization” is just a word we use to describe the compact between an individual and the polity he lives in -- he contributes some of his wealth to the state to provide for infrastructure and defense, and in return the state provides the individual with an environment in which to be productive and live among other people of like mind and temperament. The state does not (or should not) guarantee success or happiness; it exists simply to provide ground in which those crops may flourish. But this civilizational compact is predicated on the idea that every member pulls his own weight and does not impose an undue burden on the rest of the citizens. When too many citizens consume more than they produce, it breaks the compact: it forces the producers to shoulder others' burdens in addition to their own. Even if the producers are willing to do this for a time, the end result must be insolvency -- because the aggregate income will always be outstripped by the obligations imposed.

The biggest fallacy of the modern fiat-money age is that citizens and politicians alike think we can raise our “income” any time we want by printing currency. In effect, there is a belief that we can bring real-world wealth into being ex nihilo via the printing-press, or avoid insolvency by issuing yet more debt. (Avoid insolvency by taking on even more debt? Only in the halls of Washington D.C. does that make any sense at all.) But what we need to remember is that money itself has no intrinsic value (especially fiat currency); it’s a signifier for things that do have value (like your own labor, or some good or service). Simply printing more currency actually dilutes the total wealth of the nation; it does not add to it. It actually increases the danger of insolvency because it provides the illusion of greater income, and hence leads to even more unsustainable spending.

(I won't address taxation here because tax is not additive in any real sense; it is redistributive. In energy terms, tax revenues do not add energy to the system but simply redirect existing energy to other purposes.)

The take-away is this: the sovereign-debt crisis that has grown out of the 2008 financial crisis is not a problem of liquidity. Many industrialized nations are simply insolvent. Their income will probably never be enough to meet their obligations. GDPs across the G20 nations have basically recovered from their 2008 lows, and have even increased (though at a slower rate of growth than many desire). However, their debt and social-welfare spending have outstripped the growth in their economies by a significant amount, and this disparity is going to get larger and larger with every year that goes by.

The welfare state has bankrupted us all.


In AoSHQ shorthand, you can say it this way:

Illiquid: You're broke.
Insolvent: You're boned.

digg this
posted by Monty at 09:02 AM

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