Liquidity vs. Solvency
December 16, 2007
The difference between a liquidity crisis and a solvency crisis is not real difficult to understand, but you can be sure that when you are in the middle of a solvency crisis, most of the interested parties will be making it as difficult as possible. I even warned against exactly this outcome in my book, on page 177 (which I wrote in 2000):
It is of utmost importance to distinguish between a liquidity crisis and a solvency crisis. Often, banks or corporations–not to mention the politicians that serve them–are eager to blur the distinction, since an insolvent bank will remain in operation if it is able to claim it faces a liquidity crisis (as opposed to a solvency crisis) and secure a loan from the government. Certain economists are equally eager to blur the distinction as a justification for excessive base money creation and currency devaluation.
Well, does that sound just a little like something we’re seeing today? I think it does.
These are topics that are much too large to deal with completely here, but we will at least try to start the discussion. A liquidity crisis is when you are solvent (i.e., your financials are in good shape) but you need some cash pronto to pay a bill. For example, let’s say you are in a restaurant and the bill comes, and you find that you don’t have enough money in your wallet. Now, you might have a good job, no debt, own your house, and have $250,000 in the bank. However, none of that matters when you are in the restaurant. “I can’t pay you, but I have $250,000 in the bank!” Yeah, right. That $250,000 might be in a one-year CD. You have a problem, which you can resolve with a short-term loan, like a credit card. In time, you can pay off the loan, and no harm is done.
This is a liquidity crisis at one specific institution. In the past, before 1920, sometimes everyone had a liquidity crisis at once. Everyone was short of cash, and thus nobody could lend to anyone else, no matter how good their credit was. The money simply did not exist. This is a systemic liquidity crisis, and was resolved by the development of a “lender of last resort,” which eventually became today’s central banks. The characteristic symptom of a systemic liquidity crisis was super-high short-term interbank interest rates, often in excess of 20% or even 100%. The original central banks (such as the 19th century Bank of England) resolved this problem via its discount rate. When short-term interbank rates reached super-high levels (in practice 10% or higher), it was a sign that the BoE should step in as a “lender of last resort” and make loans with literally freshly-printed banknotes (in many cases), thus relieving the systemwide shortage of cash. As the high-interest loans were paid back, the base money supply naturally contracted.
Remember that easy diagnosis: the genuine systemic liquidity shortage crisis is identified by super-high short-term interbank rates. There may be other reasons for super-high rates, notably hyperinflation, but you can be sure that if you don’t see super-high rates (in excess of 10% and likely much higher) then there is no systemic liquidity crisis. Low interest rates means that other people can borrow money, just not you, because you are insolvent.
This is all probably rather hard to understand, but if you read Chapter 8 of my book, you will get a better idea of what I mean, including some real-life examples.
After the introduction of the Fed in 1913, which was specifically designed to prevent liquidity shortage crises, there has never been another liquidity shortage crisis in the US and probably the whole world. With the Fed’s present interest-rate targeting system, it simply cannot arise. The plan worked. The liquidity shortage crisis now an archaic problem that no longer exists, sort of like smallpox.
Instead, what we have is the solvency crisis. The solvency crisis is: you lost your job, have no savings, maxed out all your credit cards, bought a house on a neg-am suicide mortgage, and now your mortgage is resetting to a higher rate and your monthly bills double. You can’t make the payments, and nobody will loan you money either, because you can’t pay the loan back. You’re sunk — or insolvent, the technical term. However, if someone does loan you money, you may keep the game going a little longer, even though you are still just as insolvent. Probably more insolvent, since now you owe even more. Refi anyone?
Banks today have no real shortage of liquidity. The Fed has taken every imaginable step to guarantee that is the case. Interbank rates are a bit elevated (LIBOR vs Treasuries), but that is a measure of risk premia against insolvency. The problem today is that banks could be insolvent.
Banks become insolvent for the most boring reasons, namely they loan money to people (or corporations) that don’t pay it back. If borrowers don’t pay the money back, then the bank can’t pay its own creditors, which are known as depositors. This is how you go bust in the banking business. Pretty simple. Notice that it has nothing to do with “liquidity.”
A company may be insolvent, but it does not go bankrupt until it defaults on one of its obligations. Thus, if the Fed or government keeps making loans to the banks, or guarantees loans to the banks (via deposit insurance or otherwise) which is almost the same thing, then the banks will always have money to pay their own obligations. This is how the totally-bankrupt S&Ls were able to operate for many years in the 1980s without being shut down. Today, Countrywide Financial would have defaulted for certain if not for rather heavy intervention by government lenders, notably the FHLB. This is why banks are always eager to claim they are “illiquid” when they are really insolvent.
I am not too much opposed to government intervention, since one genuine lesson from the 1930s was that cascading bankruptcies among banks can lead to major irreparable economic damage. Let’s say you are solvent, with your “$250,000 in the bank,” but then your bank goes bust. Now you don’t have $250,000 anymore, and maybe you start defaulting as well on your own bills. Then, the company which was expecting to get paid by you doesn’t have any cash, and starts defaulting on its debt, which leads to unemployment and more bank failures, and then everyone goes and tries to withdraw their deposits at once, and so on and so forth. Not a good situation.
This is a place where the Fed can perhaps step in, although it is probably better yet for the government itself to step in and recapitalize the banks (give them more money to pay off their losses). This is quite common in banking crises around the world, although the US hasn’t itself had a government-recapitalization episode yet. (There’s a big difference between giving a bank a loan, which must be paid back and doesn’t increase shareholder’s equity, and a capital investment, which isn’t paid back and does increase shareholders’ equity.)
This is really the best way to deal with systemic banking system problems. It’s not perfect, as the government becomes a major shareholder in the banks, with all sorts of potential consequences. Usually, however, the government behaves itself and is happy to divest its investment at the first opportunity. We’ve seen this happen in Japan in recent years, and it has happened throughout Asia and Latin America in the last couple decades. If the US government invested $200 billion in the top ten banks, you’d see everyone breathe a sigh of relief (except shareholders, who would be badly diluted).
However, at this point we get another phenomenon. The Fed, as it is trying to keep the banks afloat, would dearly like to devalue the currency. They don’t call it that. Typically it’s called “lowering interest rates” or something like that. Look at the yield curve today. The 10 year Treasury bond is at 4.23%. That’s certainly low enough. Under a proper monetary system, like a gold standard for example, interest rates are low to begin with, and naturally decline with the onset of recession.
The advantage of devaluation is not that interest rates are lower. That’s just a cover story. The advantage is that it makes debts easier to pay back in a devalued currency. Since banks’ problem is that people aren’t paying their debts back, a devaluation can help ease that problem, potentially. Of course, many other problems are created. Nevertheless, devaluation is effective, to some degree, of partially relieving the issue of debt default. With enough inflation, you could make house prices go up again in nominal terms. Maybe way up! Devaluation can also help alive many other depression symptoms. A “competitive advantage” is gained with trading partners. Salaries are effectively reduced, which may help reduce unemployment. Obviously, there is a price to pay for this, and it is not a small one. You can’t devalue you way to prosperity by periodically slashing real salaries and savings. I talked about the differences between a regular depression (with stable money, as was the case in the 1930s before the devaluations), and an inflationary depression earlier this year:
Zimbabwe is having an inflationary depression right now.
Now this point — this very point — is one major reason why we still have floating currencies today. You can probably see that if the Fed makes a loan to a bank, or if the government recapitalizes a bank, neither of these necessarily have any currency consequences. It’s much the same as if a private institution made a loan or an equity investment in a bank. The only real reason for central bank currency manipulation today is to devalue the currency at an opportune time.
There is a large group of people who thinks the Fed should have devalued the currency sooner in the 1930s, in response to the collapse of banks. Notice that I said “sooner.” Because the dollar was indeed devalued, in 1933. The Fed didn’t have much to do with this devaluation, which was carried out by the White House. This is also interesting — if you decide that it is prudent to have a devaluation, it is not necessary to have a Fed to do so, nor is it necessary to have a floating currency or leave the gold standard. Roosevelt devalued from $20.67/oz. of gold at the start of 1933 to $35/oz. in 1934, and repegged the dollar at $35/oz., where it stayed until 1971. This devaluation was really in response to devaluations in Europe, Germany in August 1931 and especially Britain in September 1931, followed by Japan in December 1931. Since much of the world consisted of European empires at the time, the entire empire devalued at once, so these devaluations were mirrored in currencies around the world. This allowed the devaluing countries to “beggar thy neighbor” tradewise, which didn’t go over so well in a Depression. The US devaluation of 1933 really just returned the USD/GBP exchange rate to its pre-1930 level. These devaluations didn’t really help all that much, and unemployment was still in double-digits five years later.
These devaluations, despite their long-term consequences, probably did help crushed debtors to some extent. Commodity prices made a nice rebound and moved higher in nominal terms, which helped the finances of farmers, for example. However, most of the damage on that front was already done. Banks already had their great wave of collapse, culminating in 1933. There isn’t much you can do for debtors after they have been bankrupted. All the nasty accounting and legal bits, the cessation of operations and the transfer of assets, have already transpired.
So, with all this in mind, the idea that a currency devaluation can help avoid the catastrophic consequences of widespread bank failure (this in the days before deposit insurance also), and also the idea that the devaluation should be quick, obviously before banks fail, has a certain logic. It is not so surprising that people have latched onto this idea. It’s not the best solution, of course. The best solution would have been to avoid or resolve the things that caused the Great Depression in the first place, namely the explosion in tariffs worldwide followed by an explosion in domestic taxes when the recession impaired government tax revenue. Second, if saving banks is the goal, it is better to do so via other forms of government intervention, such as deposit insurance and recapitalization. Actually, banks probably couldn’t have been saved even if currencies had been devalued relatively early, in June 1930 for example. It takes a while for the effects of inflation to be felt in people’s ability to make debt payments.
Alas, this reasonable, if second-rate, argument for devaluation is a little too frank for economists today. Or, maybe it was a little too frank for economists of the 1930s. In 1930, the British Pound had maintained its gold parity value since 1698, and in the US the dollar had maintained its gold parity value since 1789 (and also earlier since that parity actually dates from Colonial times). A devaluation was something that simply never, ever happened, and if it did happen, during wartime for example, it was later fixed. As a result, John Maynard Keynes felt the need to disguise his devaluation arguments in all sort of quasi-mathematical mumbo-jumbo and interest-rate/demand nonsense. This was such a big success for Keynes that young tenure-seekers have been pulling this little trick ever since, including our very own Ben Bernanke, who also made his career on the argument that the Great Depression would have been solved by a quick devaluation.
Economists are typically political creatures. We see this today in Paul Krugman and Larry Kudlow, both bright and talented economists, who nevertheless have volunteered to be paid shills for their respective political parties. If the Democratic Party, in its backroom strategy meetings of non-economists, decides that an upper-income tax hike is the way to go, then Paul Krugman puts his nose to the grindstone and thinks of all sorts of ingenious arguments why an upper-income tax hike is the solution to the U.S.’s economic problems. Likewise, if Karl Rove and other non-economists from the Republican wing decide that there is no recession, nor even a hint of one, then Larry Kudlow wracks his brain to think of every conceivable way he can paint a happy face on the deteriorating U.S. economy.
(Kudlow worked at OMB during Reagan. Both Kudlow and Krugman are probably aiming for high office in future administrations. With that in mind, their behavior is perfectly sensible, even necessary, as a strong willingness to go along with the plan, and a talent for spin, is more important for most presidential appointers than any skill at actually producing favorable economic outcomes. Look at Condi Rice, who has no abilities except for a world-class talent for butt-kissing.)
I bring this up in reference to John Maynard Keynes. His book, the General Theory of Employment, Interest, and Money, came out in 1936, well after governments had already devalued in 1931-1933. It was really a justification for what had already happened, and what was shown to be already politically acceptable.
This tendency to dance around the subject, to not really talk about the real point, which is currency devaluation, was also shared by the conservatives. In the 1930s, most of the screwups were due to the conservatives, including both the tariffs and domestic tax hikes. Conservatives were criticized for “doing nothing,” although they were most certainly doing something (tax hikes) and it was all bad. The do-nothing aspects, such as limiting welfare distributions in deference to the budget deficit and taking a hands-off approach to bank collapse, were also judged to be failures in time. The conservatives also quietly adopted the notion that a bit of currency devaluation could be a good thing.
Thus, on the conservative side, we have Milton Friedman arriving with arguments just as opaque and convoluted as those of Keynes (well, maybe not quite), which come to the same conclusion by a slightly different road (“money supply” instead of interest rates). That conclusion is just as unspoken in Friedman’s Monetary History of the United States, 1867-1960 as it is in Keynes’ book: currency devaluation, and not by the simple and overt expedient of executive order, as Roosevelt accomplished, but via the Federal Reserve, and in a certain covert fashion.
We are going to stop there for now, but we will pick up this topic again soon.