Liquidity Versus Solvency

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jun 20, 2012 1:24:07 PM

and tagged Debt Crisis

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Two sets of meetings going on now are expected to help resolve the current financial and economic problems. The G20 meeting—followed by a meeting planned for this Friday of Germany, France, Spain, and Italy to prep for the eurozone summit next week—is one set, and the Federal Reserve meeting, which will end this afternoon, is the other.

The contrast between the two is instructive. On the one hand, the first set is a group meeting followed by a pre-meeting meeting for another meeting. The other is a regularly scheduled get-together with standard procedures and announcements. This basically describes the difference between European attempts to address problems and that of the U.S., and it illustrates why the U.S. response has been both more organized and more effective.

Looking a layer deeper, the structure of the political entities requires the two different approaches. The U.S. is a fiscal union with a unified approach and well-defined fiscal transfer and monetary structures. The European Union (EU) and eurozone are making it up as they go along. They have no standard mechanism in place for one region to subsidize another when needed. Consequently, the institutional problem—meetings about meetings to set up meetings—won’t go away until there is a solid political structure. That is essentially what will be discussed at the next several EU gatherings.

What is fascinating, however, is that, even when a solid political structure is in place—and even when the Germans and everyone else have agreed on how to proceed—this will only enable them to start discussing answers to the real questions: How do we solve the problem? And, even more important, who will pay? The problem is that there simply is not enough money to pay the existing debts, and providing more temporary money to temporarily kick the can down the road will not change that basic fact.

Once again, the contrast with the U.S. is instructive. In the U.S., all states (except Vermont) and most subsidiary entities are required to have balanced budgets. Though often honored in the breach, this has resulted in substantial cuts in government spending at all levels (except at the federal level). In fact, today’s New York Times has a front page article, “Public Workers Face New Layoffs, Hurting Recovery,” talking about how government jobs are down by 659,000 since 2009. Households and businesses are also deleveraging.

On top of the voluntary cuts and deleveraging, there have been substantial write-offs of bad debt by the banking sector in mortgages and consumer lending. The net effect—Federal government aside—has been a big drop in debt outstanding and a much healthier financial system.

Spain—to put it mildly—has not done the same thing. Nor have most of the other peripheral eurozone countries. They have taken the bailout money given them and continued politics as usual, without making any hard decisions—or at least not as hard as they need to be. And they were allowed to do that because, to date, the eurozone has focused on providing liquidity to get through the day, rather than on looking to arrive at actual solvency.

Aspirins for the headache don’t cure the brain tumor. The reality is this: with lots of bad debt that no one will—or can—pay back, at some point someone has to recognize the losses.

Who that will be is the question.

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Tune in to Bloomberg Radio's Bloomberg Businessweek on Friday, February 28, at 3:45 P.M. ET to hear Brad talk about the market. Stream the show live at https://www.bloombergradio.com/, listen through SiriusXM 119, or download Bloomberg's app, Bloomberg Radio+.

Tune into Yahoo Finance's The Final Round on Thursday, March 12, between 2:50 and 4:00 P.M. ET to hear Brad talk about the market. Exact interview time will be updated once confirmed. Watch at finance.yahoo.com

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