Liquidity Crisis vs. Solvency Crisis

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In the comments on a different site I saw someone give this analogy for our current financial problems:

“A tourist stops at a motel and gives the manager a $100 cash deposit while he looks at the rooms. The manger runs and pays off his $100 debt to the butcher. The butcher runs and pays off his $100 debt to the farmer. The farmer pays off his debt to the feed store, and then the feed store owner pays off his debt to the motel owner. The motel owner then gives the $100 depost back to the tourist.”

That’s called a liquidity crisis. Everyone’s net worth is above zero. Everyone has debts and credits, but no one can pay their debts because they can’t collect their credits. All you need to solve this problem is a little liquidity. Temporary use of some money that can be later returned. Low interest small business loans would work nicely.

But there’s a different kind of financial problem called a solvency crisis. Imagine instead that a restaurant owner takes out a small business loan to stock his wine cellar. The next day Bernie Madoff comes in and drinks $1000 of wine, paying with cash. The restaurant owner turns around and invests that cash in Madoff’s hedge fund. The next day Madoff comes back and drinks another $1000 of wine, paying with cash (the same $1000 bill he used yesterday), and the restaurant owner turns around and invests that money with Madoff too. This continues ten times. Madoff has drunk $10,000 of wine, and has a $10,000 debt (the investment he is supposed to eventually return to the restaurant owner), but he only has $1000 of cash to repay that debt. Madoff has a solvency problem. His net worth is less than zero. Temporary use of some cash, to be paid back later, would not solve this problem. This situation is different because value was actually destroyed. The $1000 of cash still exists, but $10,000 of wine disappeared into Madoff’s stomach, and Madoff didn’t produce anything of equal value he could use to pay for the wine.

If the restaurant owner was counting on his Madoff investment to pay off his small business loan he’s got a problem too. He may think he has a liquidity problem (as soon as Madoff pays me I can pay my debts), but really Madoff is never going to pay. Madoff’s solvency problem creates a solvency problem for the restaurant owner too.

Our current financial situation is a giant artificial solvency crisis. Lots of people can’t make their mortgage payments because they lost their jobs, and they can’t sell their houses because they are underwater because of recent steep price declines. It appears they have a net worth less than zero. This solvency crisis is somewhat artificial because it has been created by a liquidity crisis which is causing all the job losses and the lack of house buyers causing the price declines. But the liquidity crisis was caused by a real underlying solvency crisis. People funded unaffordable consumption with either deficit spending (home equity loans and credit cards) or fictitious investment profits (selling stocks or real-estate at bubble prices). Whoever made those loans or bought at bubble prices now has a solvency problem, and that solvency problem can propagate to whoever they owe money to.

It’s important to think about this in terms of stability. Airplane manufacturers think a lot about stability. When a gust of wind tips an airplane a little to the side does it naturally come back to center, or spin out of control? Having stability is a good thing, but stability can be sacrificed for performance. Acrobatic airplanes can do those amazing flips and spins because they are much less stable than a jumbo jet. But there’s a reason airlines don’t fly passengers from New York to LA every day in high performance acrobatic airplanes.

One of the fundamental root causes of our current financial crisis is that our financial system was unstable. A small solvency crisis created a bigger liquidity crisis, which created an even bigger solvency crisis. A small gust of wind tipped our wing a little and we spun out of control.

During the bubble, financial firms thought that exotic financial instruments and high leverage were great because they increased financial performance. But they were ignoring stability. We managed to build our economy into a high performance acrobatic plane instead of a reliable jumbo jet. Individuals should be held responsible for a personal solvency crisis caused by unaffordable consumption, but society should design the financial system to be stable so that those individual solvency problems don’t propagate and amplify. That is achieved with boring financial regulations like margin requirements on banks, and loan-to-value requirements on mortgages.

9 thoughts on “Liquidity Crisis vs. Solvency Crisis”

  1. MAN YOU ARE GOOD! I am a Yr 12 Economics student In Aust and I have an exam tommorow, NICE WINE + AIRPLANE (here we call it an “AEROPLANE” – same diff.) metaphors. Fantastic. Send it to all the broadsheets that said that economists “can’t predict recessions” because they want a unstable, bubble based “performance” financial system essentially based on – nothing. Thanks for clearing it all up. Cheers man!!!!!!! =)

  3. Excellent article. Think we can now start to apply this to nations as well, take Greece for example. It just goes to show how deep-rooted these problems are.

  4. Thanks for the compliments.

    I wrote this article when I realized that there are a lot of people in financial trouble today who made responsible decisions based on a reasonable expectation of functional, liquid housing and job markets. For example, they bought a house with 20% down and mortgage payments that they could afford with their then job.

    There are a lot of conservative pundits who like to say that anyone who is in financial trouble must have been irresponsible. But really, what more could you expect from someone? Those decisions were responsible in their situation. They are only in trouble because the whole system collapsed because of the irresponsibility of a much smaller number of people and the fact that the system didn’t have enough financial damping to make it stable.

    Those same pundits also say that capitalism is perfect and we shouldn’t have the kind of regulations that provide financial damping.

    It would be a good idea for nations like Greece to keep this in mind as well. Unfortunately, politicians are also motivated to make the numbers look good in the short term just like corporate CEOs.

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