Sunday, November 27, 2011

Solvency not liquidity

"Four years into the crisis it is surely time to accept that the underlying problem is one of solvency not liquidity – solvency of banks and solvency of countries. Of course, the provision of additional liquidity support to countries and institutions in trouble can buy valuable time. But that time will prove valuable only if it is used to tackle the underlying problem.......But the underlying problems of excessive debt have not gone away. As a result, markets are now posing new questions about the solvency of banks and indeed governments themselves." Mervyn King, Governor of the Bank of England, 18th October 2011.

The balance sheet recession needs liquidity to provide for the fluid transfer of assets, but it cannot solve the recession. The problem is still solvency and that requires time and effort by both government, consumers, and businesses. The cost is lower spending in order to pay-down debt. The can be write-offs which will be helpful only to the extent that the borrowers have a higher propensity to consume and will not make the same mistakes again. Lenders will be hurt which has a direct wealth effect. Governments have to cut services. Businesses will have to delay investments. 

Governor King has it right. Liquidity buys time but does not fix balance sheets.

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