Europe and the Solvency Issue

More and more people are becoming aware of the fact that the problem in Europe is one of solvency and not liquidity! Yesterday, the European Central Bank warned “that euro-zone banks face a €195 billion in write-downs this year and next due to an economic outlook that remained ’clouded by uncertainty.’” (See http://online.wsj.com/article/SB20001424052748703406604575278620471963334.html#mod=todays_us_money_and_investing.) This is equivalent to slightly more than $239 billion.

Not only that but it is estimated that these banks will need to refinance roughly €800 by the end of 2010. (See http://www.nytimes.com/2010/06/01/business/global/01ecb.html?ref=business.) This is equivalent to about $984 billion or roughly $1.0 trillion.

More and more people are beginning to realize that countries within the European Union are going to have to restructure loans and this will mean that many euro-zone banks are going to have to write down many of the assets they have on their balance sheets. Hence, we face the problem of the solvency of the banking system.

Why has it taken so long for these people to realize that the problem is a solvency problem?

The reason, I believe, is that the mainstream economic models we have been working with over the past 50 years have focused upon “liquidity” issues. Debt has played very little role in these models.

Yes, I know that some ‘fringe’ economists like Hyman Minsky wrote about these issues, but try and find any kind of a discussion of debt and solvency in major macroeconomic textbooks.

Many post-World War II discussions of money and the demand for money are “framed” within the terminology developed by John Maynard Keynes in the 1930s, around the term liquidity preference, “The term introduced by Keynes to denote the demand for money.” (This is from the Glossary of the macroeconomic textbook by the Keynesian economist Olivier Blanchard.)

Moving from liquidity preference we get the concept of “liquidity trap” from the Keynesian dogma: “The case where nominal interest rates are equal to zero and monetary policy cannot, therefore, decrease them further.” (This, too, comes from Blanchard.) That is, people want to hold money and don’t want to loan money to invest in plant or equipment or inventories and so forth.

Obviously, this latter possibility resonates with Keynesian fundamentalists in terms of the situation that has existed over the past year or so.

The problem with this is that the idea of liquidity preference and the liquidity trap apply to the future. People don’t want to invest privately and just want to hold money because the expectations of future investment performance are so low and so risky that money is the safer way to hold their wealth. This is why, in the Keynesian paradigm, government deficit spending works because people will buy the government debt and the government can then “invest” and put people back to work whereas the private sector cannot.

But, what if the problem is that people and businesses (including banks) are so in debt that they cannot spend and that the cash they are holding is to provide them with funds to exist on in the future? That is, what if people and businesses are bankrupt or are facing bankruptcy because of the debt they have accumulated and are hoarding their wealth in very liquid assets so that they can buy what they need out of what remains of their wealth?

Maybe economic cycles are connected with credit inflations or debt deflations, cumulative buildups of debt followed by the need to unwind the excessive use of leverage built up in the earlier period. This cyclical behavior contains the problem of solvency, not liquidity. (Keynes, interested in the short run, focused on liquidity. Irving Fisher, the prominent American economist from the 1920s, focused on the longer run and wrote about debt deflations.)

It seems that economic policymakers in Europe (and in the United States) have been interpreting the problems of the last two years or so as a liquidity problem. Hence the responses of the leaders of the European Union have been couched in terms of solving their economic and fiscal issues by making sure that there is sufficient liquidity in financial markets for them to continue to function. Yet, the problems have not gone away because the issues of restructuring the debt and asset write-downs have either been ignored or pushed under the covers so that they don’t have to be discussed.

This has been true in the United States as well. The United States Treasury Department responded with the TARP program that was, at least initially, aimed at providing liquidity for ill-liquid assets on the books of banks and other institutions. (See my post of November 16, 2008,”The Bailout Plan: Did Bernanke Panic?” http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.) Furthermore, much of the effort of the Federal Reserve in 2008 and 2009 was aimed at providing liquidity to the banking system and the financial markets and not to problems of solvency.

In fact, I have been arguing over the last six months or so that the real reason why the Federal Reserve is keeping its target Federal Funds rate so low is that there are real asset problems in many of the small- to medium sized commercial banks. The Fed is keeping the rates low so as to help the banking system escape the “solvency” problem of the smaller banks from getting worse while the FDIC works through the liquidation process. Note, again, that the FDIC is closing more than 3.5 banks per week through May 28, 2010 and has 775 banks (There are about one out of every eight commercial banks on the problem list!) on its watch list, a number that is still increasing every quarter.

“The challenges for banks in the 16-nation euro-zone include exposure to a weakening commercial real estate market, hundreds of billions of euros in bad debts, economic problems in East European countries, and a potential collision between the banks’ own substantial refinancing needs and government demand for additional loans.” This quote is taken from the New York Times article referenced above.

The source of this concern? The European Central Bank!

The problem with a solvency crisis is that ultimately assets must be written down to more realistic values. In the cumulative process that occurs in the euphoric credit inflation that precedes a debt problem, asset values attain unrealistic levels. That is why people and businesses (including banks) continue to leverage up their balance sheets.

Valuations eventually must be put on a more realistic basis. This is where the European Union is at the present time. The unanswered question is, how far must valuations be reduced to achieve this realistic basis. And, of course, the bigger concern is whether or not these reductions can be achieved without inducing a cumulative debt deflation. No one really has the answer to either of these questions before the fact.

However, the excesses of the past must be paid for!