Nonidentical Twins: Solvency and Liquidity (III)

This is the third part of an irregular series on solvency and liquidity.  This time, though, I am not focusing on corporations, or accounting rules, but on countries and municipalities.

With the crisis in the Eurozone, there are times of calm, and then times of panic, with seemingly little warning for transitions.  Let me try to explain why this happens, even though it won’t explain why it happens on a particular day.

A country with a profligate fiscal policy builds up debt beyond its ability to repay if bad times were to come, but times are good, the country is growing rapidly, and most think that there will be more than adequate ability to repay given the growth of GDP.

Or, the financial sector grows of a nation far more rapidly than GDP, abut again, in boom times, the profits of the banks are roaring ahead, and only cowards or bears would question the prosperity of a boom.

But the truth is, during a credit-driven boom (whether governmental, financial, or other), much of the supposed prosperity is a mirage.  The additional leverage pushes up asset prices until the cost of financing the assets exceeds the yield the assets throw off by a small margin.  Economic agents have to rely on capital gains to make money, and that is where bubbles pop, and go into reverse, with a vengeance.

With nations, an overleveraged situation is revealed during a bear market.  Asset prices shrink.  Incomes shrink.  Demand for welfare payments rise.  Governments that relied on expanding asset prices are revealed to be the spendthrifts that they are.

Now, when a government is overleveraged, but interest rates are low, the situation is potentially unstable.  A rise in rates could tip the scales.  Market actors would conclude that they can’t survive at rates high than a certain threshold, so sell the debt now, in case rates would get so high.  That action forces rates higher, leading to a self-reinforcing panic.

Sometimes this happens in advance of a debt refinancing, leading some politicians and bureaucrats to say the forever bogus phrase, “This is not a solvency crisis, this is a liquidity crisis.”  Sorry, if you play near the cliff, don’t complain if you happen to fall off.

Liquidity crises do not happen to governments with low debt levels.  Liquidity crises are solvency crises during the panic phase, before they are revealed to be solvency crises alone.

It is difficult to change government behavior, because the politics of reducing spending, or raising taxes is tough.  Once a crisis hits, there are protests.  People point at shadowy interests that are denying them the illusionary prosperity of the boom; conspiracy theories thrive.

With the Eurozone, there are contagion effects; panics in one nation prompt investors to look at other nations, and leave weak situations.  Crises separate good and bad credits.  That may push bad credits over the edge.  Again, never play near the cliff; always ask, “Could we survive easily in bad times?”

The difficulty for the strong nations of the Eurozone is that their banks lent a lot to the fringe nations that are failing.  Thus the strong are likely to bail out the fringe, though a more prudent course would be to bail out their own banks after a promise limiting lending abroad.  The real political question is what is the price that Germany will charge to bail out the Euro?  What sovereignty will the fringe have to give up?  And what will the German and Fringe electorates tolerate?  Perhaps the intersection set is null.  No agreement.  At that point the Eurozone shrinks or ends.

The proper solution for the Eurozone fringe, and other deadbeats in this crisis, is to negotiate writedowns of debt, and cut them off from borrowing at the rate they were accustomed to receive.  Recognize losses, and wean them off credit.  If not, let them fail, and bail out your own banks, which is cheaper than bailing out the fringe.

Pressures are building.  If the Eurozone survives in its present form, it will be because Germany bailed it out, at some political price that they will specify.  Investors should look at cash financing schedules and balance sheets to evaluate the future solvency of Eurozone nations.

And, lest the US smirk, the same exercise will come here, reserve currency or not.