Is the developed world merely illiquid or actually insolvent?

Coming up empty

Wherever you look in the world today you see economic problems. And whether it’s Britain, Europe, or the United States, with governments struggling under spiralling debts, what power there is to solve or at lease ease these problems is said to rest in the hands of central bankers.

Central banking grows out of maturity mismatch in banks. For example, you might pay £100 into a bank and be able to withdraw it at any time. The bank, on the other hand, might lend it to someone with a repayment date decades in the future, a mortgage for instance. If the bank has loaned your £100 out with a maturity of 30 years, if you turn up before those 30 years is up, the bank cannot give you your money.

In this case the bank faces a problem of liquidity. It has the assets (in the form of future mortgage payments) to cover all the claims that depositors could make against it. But it might not, in fact it rarely will have, enough liquid cash on hand to meet these demands if depositors all made them at once because these payments are not due until some point in the future.

It was because of repeated shortages of liquidity which lead to bank failures and economic disturbance that central banks evolved their role as ‘lender of last resort’ to the financial sector (many, like the Bank of England, had come into being solely to fulfil the ‘lender of last resort’ role for the government).

When banks were faced with depositors trying to withdraw lots of deposits against assets which wouldn’t return until a future date, central banks would tide them over. In the words of Walter Bagehot in his 1873 book Lombard Street, central banks should “lend freely at a high rate, on good collateral”

It should be obvious how far modern central banking has deviated from Bagehot’s principles. True, lending could hardly be any freer, but rates are at all time lows and the collateral stinks. But there’s a more fundamental problem: central banks were designed to assist with liquidity crises – what we may be seeing is a solvency crisis.

Solvency refers to whether an institution has enough assets to cover its liabilities. If it doesn’t, if a bank, for example, is owed mortgage payments of £9 billion but has liabilities of £10 billion, it is insolvent. There is no way, even if it could liquidate its £9 billion of assets into cash immediately, that it could cover its liabilities.

Governments around the world are racking up vast debts even on official figures. Between 1990 and 2009, according to a McKinsey report, government debt rose from 57 percent of GDP in 1990 to 67 percent in 2009 and from 32 percent of GDP to 59 percent in Britain in the same period. Coming up to three sluggish years later those figures are up to around 100 percent for the US and 85 percent for Britain.

But it’s not just governments. In the US financial debt was up from 24 percent to 53 percent of GDP between 1990 and 2009. In Britain it was up from 60 percent to 154 percent of GDP. Household debt in the US rose from 59 percent to 97 percent of GDP over the period; in the UK, from 65 percent to 103 percent. Corporate debt in the US rose from 65 percent to 79 percent of GDP and in Britain it rose from 66 percent to 110 percent of GDP.

So those figures for national indebtedness which we often hear, usually around or hurtling towards 100 percent of GDP, is only the government part of the story. All told, the indebtedness of the US is around 300 percent of GDP and for Britain the figure is close to a staggering 500 percent of GDP. And this doesn’t factor in long term liabilities like pensions. It is a story repeated around the developed world.

Are these countries really suffering from a temporary tightness of cash which can be helped with a little central bank greasing? Or are they drowning in debt? Are they merely illiquid or are they actually insolvent?

As Mitch Feierstein puts it in his excellent recent book Planet Ponzi,

“Above all, where excessive debt is the problem, there exists one and only one solution: less debt. If that means that dumb creditors lose money, that’s good, a positively beneficial outcome. Simply put: too big to fail is too big to exist. The failure of some creditors will remind all the others that credit discipline matters, just as it always has done, just as it always will.

In particular, we need to relearn an old lesson: that you cannot solve a problem of excessive private sector debt by getting the government to take it over. Or by extending government guarantees to soften the hit. Or by printing money to bail out failed financial institutions. Or (in the case of the wonderfully named EFSF) by creating a rescue fund that contains no funds, only guarantees, and which is itself going to be as highly leveraged as those Eurocratic minds can devise”

The grim possibility exists that there may be too much debt in the world ever to be paid off. That means default, either overt (the PIIGS) or covert via inflation (everywhere else). Either way, there are lots of people are going to find out that their assets aren’t worth anything.

This article originally appeared at The Commentator

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