The Next Term, Part 2 of 5: Liquidity and Solvency

Yesterday’s post dealt with the similarity of politics and ideologies in the EU and US.  Today’s covers similar ground but from an economic, more mechanistic perspective.  Specifically in my mind: the problems of liquidity and solvency in an economy and the government that economy supports.  The clearer the diagnosis the better the forecast.


Illiquidity kills you fast.  It’s like severing an artery and bleeding to death.  You will collapse and die in minutes.  A tourniquet is an appropriate intervention, followed by the infusion of lots of fluids.

Insolvency kills you slow.  It’s like starving to death.  You are just as dead but it can take days.  A tourniquet won’t help at all.  A steady and reliable supply of nutrition must be secured and sustained to allow the slow recovery of strength and endurance.

Understanding the very different nature of these problems in financial terms is the key to what must be repaired and to applying the right remedy when crisis strikes.  And we’ve got one coming.

In financial terms, illiquidity is the lack of transactional funds.  Fear creates hoarding; banks experience runs; funds flee to safer havens, perhaps overseas.  The system drains and quickly grinds to a halt.  The tourniquet is the Federal Reserve in the US; the central bank in any country more generally.  The method of treatment is to tie off the loss of “blood” by stopping the bank runs, by reassuring the fearful and emptying out the hoard.  This is followed by the infusion of large amounts of short term funding into the commercial banking system to prevent collapse and re-animate trade.  Note that this does NOT include the long term purchase of sovereign or government-guaranteed debt.

In financial terms, insolvency is the inability of the economy to feed the government the amount of money necessary to fund the government’s promises and obligations, not just day to day but systemically over years and decades.  In an insolvent economy government starves slowly, borrowing to sustain itself day to day, until the borrowing can’t continue.  Then it gets Darwinian.

Depending on the politics, either the economy is starved as government seizes assets and extracts more than the economy can bear to lose and still remain strong and vital, or the government starves into bankruptcy.  California and Illinois are good examples of the former; government refuses to stop spending, embarks on a confiscatory taxation regime.  Predictably, those two state’s economies are gradually starving to death.  Productive people are fleeing in droves.  Greece is an example of both government and economy in states of starvation, which is what makes Greece so unusual.  This is what debt traps look like.

The key to recovery is obvious: act to 1) reduce government spending and end the demand for more taxation, thereby 2) allowing the economy to retain enough “food” to regenerate itself into a state of health and solvency, thereby 3) becoming able once again to sustain a rational level of government spending.  I call it re-establishing economic balance between an economy and the government it supports.  Critics of this process derisively call it “austerity” and demand an end to it.  As though there were another way.  There is no other way.  These critics are fools.

Europe has since 2008 been caught in both liquidity and solvency crises simultaneously.  The confusion you’ve witnessed there over the last four years is the flopping back and forth between trying to alleviate the illiquidity, which perversely allows politicians to ignore the insolvency issues, or focusing on the insolvency issues, which has the effect of triggering the illiquidity that bleeds the very economy that must be grown back to health.  And if this paragraph sounds confusing, that’s because it’s accurate!

The entry of the ECB last December and again in February, with it’s €1 Trillion in LTRO infusions of cash into the financial pipelines, is correctly seen as putting the liquidity issues on the back burner.  But this is just a temporary fix.  An economy incapable of operating in a solvent manner will eventually shrink sufficiently to create another governmental liquidity crisis, so the most that can be said of the ECB’s effort is that it bought time.  Nothing more.  And the price one pays for that extra time, as nothing is free, is a loss of purchasing power in the economy.  Call it a bump up in inflation if you wish.  Same thing either way: it’s a degradation of the currency by degrees, reducing buying power within the economy you’re trying to grow.  (No, Virginia, inflation is not rising prices … that’s naive … inflation is the devaluation of the currency, and that is a very critical distinction and the key to good policy; more than just a quibble about words.)

Just as bad as the fouling of the currency is the pass these liquidity infusions give politicians and institutions, allowing them to put off truly fixing the solvency problems that exist.  Solutions delayed are problems multiplied.  This was in the European edition of the WSJ yesterday (April 2d).  Read the whole article here.

LONDON—Even as the European banking crisis shows signs of easing, lenders across the Continent are engaging in a variety of maneuvers to avoid, or at least delay, coming to terms with potential problems lurking on their books.

Some banks are concocting unorthodox structures designed to improve all-important capital ratios, without raising new capital or moving unwanted assets off their balance sheets. Others are engaging in complex transactions with struggling customers to help temporarily avoid loan defaults—but possibly exposing the lenders to future problems.

Banks now have greater flexibility to pursue such tactics because of the roughly €1 trillion ($1.33 trillion) of cheap three-year loans that the European Central Bank recently handed out to at least 800 lenders. The program, known as the Long-Term Refinancing Operation, or LTRO, is widely credited with averting a possible catastrophe as banks struggled to pay off their maturing debts.

But by granting the new lease on life, the ECB program also has enabled the industry to delay its cleanup process, according to some bankers, investors and other experts.

“The LTRO has allowed for an extension of the period before which bank reconstruction is embraced, and the damage for the euro area could be material,” said Alastair Ryan, a banking analyst with UBS.

The tactics are most prevalent in Spain, where banks are awash in ECB loans but also are buckling under the increasing weight of bad real-estate loans. Lenders are making accommodations to small- and medium-size borrowers that take immediate heat off their customers, but possibly only kick problems to a later date.

Europe’s “austerity” ( I HATE that word) policies are currently being discussed and debated in all 27 EU countries, including Germany.  They are efforts to get at the root causes of the insolvency issues: too-ravenous government and too-starved economies.  Some have been enacted.  They involve cutting bureaucracy, reducing pensions, paring back various entitlements etc.  This is good but it won’t be enough.  What must be done and has yet to show up in the policy mix … changes a flood of liquidity has allowed to be delayed … is to liberalize work rules: eliminate virtual lifetime employment law that essentially says if you hire someone full-time you own them forever; cut featherbedding union rules; open up state-protected industries to new entrants and competition; radically reduce the bureaucracy and regulation that stifles new business formation.  None of these cures has gotten any more than lip service so far in Europe.  (In a stunning display of stupidity, here in the US we are doing precisely the opposite: adding new regulation and bureaucracy at record pace.)  The reason these reforms are not forthcoming is obvious: unions hate them, and in Europe unions rule.

And that brings me to the US over the next few years.  I think there are several conclusions that make sense.

First conclusion:  we don’t have a liquidity crisis at the moment.  We had one in 2008-2009 and the Fed dumped $2.3 Trillion into the system (QE1, QE2, Twist).  IOW, the Fed threw a huge tourniquet around the wound.  The Federal Reserve, unlike the inflation-phobic ECB, is depression-phobic.  This is important, because if we can’t solve our solvency issues, grow our economy, we Americans are much less likely to experience a deflation or depression than a repeat of the 1970′s, with much higher and persistent inflation.  The Fed has clearly shown itself much more willing than the ECB to print as much money as necessary to paper over the insolvency of the US government, without regard to the inflation damage that potentially creates, because the alternative is in the judgment of the Fed much worse.  This has led the Fed to do what to date the ECB has not: make sizable, direct, long term purchases of sovereign and government-guaranteed debt.

There will eventually come a liquidity crisis, imho, that the Fed will not be able to contain.  That is what I’ve been saying will arrive in late 2013.  It will likely be initiated by a rise in interest rates, making the interest payments on the government’s then-$17 to 18 Trillion in debt increasingly unaffordable.  The rise in rates will be imposed by the markets, just as has happened repeatedly in Europe.  The Fed will find … unlike today, when printing more money is holding interest rates down … that pumping more money into the system will NOT cause rates to fall.  What the Fed discovered in the 1970′s it will again find in 2013: infusions will force rates up, because they will be seen as permanent and inflationary by the markets, while infusions today are seen as temporary and non-inflationary.  This change of expectations will call the Fed’s bluff.

So, it will be rising rates if the Fed does nothing and allows the government’s new debt issuance to overwhelm private demand, or more rapidly rising rates if the Fed pumps out more money to buy more sovereign debt.  Some choice, huh?  There is a limit to the Fed’s ability to delay the inevitable, and Ben Bernanke knows this very, very well.  What can’t continue forever will necessarily stop.

High interest rates on US Treasuries are the trigger that will cause the US government to “hit the wall”,  just as did high interest rates on the sovereign debt of Europe’s governments.  The trigger will be pulled because the insolvency issues we face will NOT have been addressed by our gridlocked Congress, just as Portugal’s or Ireland’s or France’s insolvency issues have not yet been addressed.  Unions are the most vocal and politically resistant to the changes noted above, changes needed to make economies more productive and efficient and competitive.  That is what is holding up the show in Europe and that will be what holds up the show in the US as well.

It’s worth noting that solvency issues cannot be dealt with by central banks.  The Fed, like the ECB, simply lacks the tools to fix issues of competitiveness, productivity, entrepreneurship and innovation in the economy.  Solvency issues are everywhere and always political issues.

Once that liquidity crisis hits, whether the Fed responds with another batch of wallpaper or not, the US will be fully into the “European insolvency crisis experience”.  Opening up the economy to entrepreneurial enterprise, a process that is largely shut down right now both in Europe and America, by eliminating the incredible glacial mass of regulations and ending the bureaucratic interference (hopefully by eliminating the bureaucrat) will take more than just a change of law.  It will take a broad change of attitude in the electorate.

Americans have been schooled by The Loud Left to think of the large-enterprise corporate world, the world of small business as well, as “evil”, corrupt and dangerous.  Evil Oil Barons.  Evil Drug Lords.  Evil Greedy Bankers.  We used to be a center-right nation but I firmly believe we are now center-left on this issue.  So whether and how much we turn the commercial economy loose will depend critically on whether we think we are freeing saviors or criminals.  This change in opinion, the understanding that government can’t write a check the private economy can’t cover, is going to take some time.  About five years and at least two elections, I’d guess.

My second conclusion is, therefore, that the massive insolvency of the US government … currently determined by the Board of Governors of the Social Security and Medicare Administration to have an unfunded liability of $100 Trillion over the next 50 years, and that is just for those two programs … will be ignored for as long as possible, both by those who are committed to the welfare state in concept, and by the general population of voters and taxpayers as well.  This insolvency will only become the centerpiece of the public debate, Paul Ryan’s budget notwithstanding, when the illiquidity crisis hits in late 2013.  We are currently in the ‘denial’ stage of the five stages of grief.  It should last another 18 months or so, in my estimation.

The next liquidity crisis will be quickly papered over by the Fed, yes, if only so they can say “we’ve done all we can”; CYA.  But the almost immediate rise in inflation, the reflection of that rise in the cost of the basics of life will, in 2014 as it did in 1978, cause a mass reaction politically, one that will make the much-maligned Tea Party seem tiny and tame.  This will be so because the economy lugging the enormous burdens of regulation and bureaucratic interference, here as in Europe, will simply not be able to grow.  The unemployment rate will rise as firms pull back on investment and risk-taking even further than they already have.

By the midpoint of the next president’s term the lid will come off.  We will, I think, experience another run into the inflation of the early to late 1970′s (regardless which party is in the White House) though not to the 13% levels we knew then and not for nearly as long.  Lessons hard learned will be remembered.  That will be followed by a severe recession like the one Paul Volcker engineered in the early 1980′s.  I make the start of that recession late 2014.  It will break, finally and fully, the inflation and the political gridlock.  Ben Bernanke will likely have to be replaced for this catharsis to occur.  The second stage in the five stages of grief is ‘anger’.  And there will be anger.  Lots of it.  In the streets.  On your street.  And at the ballot box in November, 2014.

We Americans will never bleed to death from illiquidity; there will be no New Depression.  The Fed will never allow it no matter the price.  Whether we starve to death from insolvency by our long term political refusal to grow our way out of the sovereign debt trap and individual dependency we’ve created for ourselves, clinging to our unfundable welfare state all the way to the nation’s grave, or whether we man-up and vote to take the considerable short term pain of replanting our fields and rebuilding our herds, will be the question we must answer in 2012 and 2014 elections.

I am an optimist on this question.  I have no idea exactly when Americans will decide to get serious; when wisdom will take hold.  As in Europe, however, the longer we delay the harsher the resolution will be.  I believe we will get serious sooner or later.  The welfare state will be reduced, with some parts disassembled.  80 years of welfare state expansion will be reversed.

We will rationalize our entitlements.  We will unleash our entrepreneurs and businesses; push back the regulation and bureaucracy.  We will find the political courage and unity to do this.  But not until we, like the Europeans, become convinced there is no other way to out of the debt trap.  And that could take another 2 years, just as it did in the EU.  Part 3 of 5, tomorrow.

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