dominicsoon.com/blog

The reason we are in this mess - cheap credit, a global savings imbalance, and a large fiscal expansion.

The solution - cheap credit, a global savings imbalance, and a large fiscal expansion.

At this stage of the game, some people are still puzzling about whether we’re in a liquidity crunch or a credit crisis. When presented to the man on the street, both explanations sound reasonable. To the extent that businesses find it difficult to get financing from banks, the differences may even seem academic. But the basis for Nouriel Roubini’s prophetic prediction of financial meltdown (more than a year ago) hinges precisely on this distinction.

He explains it well:

Economists distinguish between liquidity crises and insolvency/debt crises. An agent (household, firm, financial corporation, country) can experience distress either because it is illiquid or because it is insolvent; of course insolvent agents are – in most cases - also illiquid, i.e. they cannot roll over their debts.

Illiquidity occurs when the agent is solvent – i.e. it could pay its debts over time as long as such debts can be refinanced or rolled over - but he/she experiences a sudden liquidity crisis, i.e. its creditors are unwilling to roll over or refinance its claims. An insolvent debtor does not only face a liquidity problem (large amounts of debts coming to maturity, little stock of liquid reserves and no ability to refinance). It is also insolvent as it could not pay its claim over time even if there was no liquidity problem.

[T]hus, debt crises are more severe than illiquidity crises as they imply that the debtor is insolvent, i.e. bankrupt, and its debt claims will be defaulted and reduced.

The distinction matters because of the solutions. Liquidity crunches are somewhat easier to solve - simply to flood the market with easily available short-term credit for banks so that they can keep lending again. Solving a credit crunch is somewhat more complicated - no one is going to lend to a company that might go bust, no matter how much money you have. Of course, what makes things worse is that it’s difficult to assess who is teetering on the edge of bankruptcy and who isn’t.

Anna Schwartz argues Bernanke’s experience in Great Depression has been both a boon and a liability. The bank runs during the Great Depression were classic liquidity crises. This is a very different animal.

“This was [Bernanke's] claim to be worthy of running the Fed,” she says. He was “familiar with history. He knew what had been done.” But perhaps this is actually Mr. Bernanke’s biggest problem. Today’s crisis isn’t a replay of the problem in the 1930s, but our central bankers have responded by using the tools they should have used then. They are fighting the last war. The result, she argues, has been failure.

I have to agree with what Marginal Revolution says, though. Better to nibble away at the tenets of capitalism than let the whole edifice collapse into rubble.