Opinions and observations expressed on this blog reflect the authors' individual experiences and should not be construed to be financial advice. None of the members of this blog are licensed financial advisors. Please consult your own licensed financial advisor if you wish to act on any recommendations here.

Monday, November 29, 2010

Illiquidity vs. Insolvency and The European Crisis

There's a big distinction that needs to be made between illiquidity and insolvency when it comes to debt crises and it is useful for thinking about when looking at Ireland.

A crisis of liquidity arises when some kind of short term shock prevents an entity from making a regularly scheduled payment or a huge one-time crisis causes a huge blip in the flow of funds. For instance, let's say I normally can roll over a $10,000 loan every 12 months without issue, but suddenly the bank says no, leaving me with a $10,000 hole in my balance sheet. I can liquidate financial assets, but I don't have enough time to arrange everything. My friends can look at me and say, "Sure, here's 10 grand. Pay us back soon." and this is no big problem for me. A few weeks later, I am done liquidating assets and I have paid them back. This is actually kind of similar to what happened to AIG, incidentally.

Let us look at a case where I would be insolvent. Let's say I had a $500,000 mortgage and I could service it with a $120,000 income fairly easily. However, my income was based on a bunch of one-time incentive pay that I won't get again and my more regular pay is about $50,000. Combined with the mortgage, I have a large car payment, high property taxes and so on. What's more, because the economy is bad, I can't reasonably expect to increase my income any time soon. Over the next year, I am obligated to pay more than my entire gross income in these various payments. Even worse, I am $200,000 underwater on my mortgage because of the real estate slump. If you came along and said, "I'll give you a credit line of $20,000 that you have to pay back in three years." I would tell you it just doesn't matter. To use a technical term.... I'm screwed.

Europe's approach is very much like the latter, but with an added twist. They give you the credit line, but force you to take a pay cut in the form of austerity policies that reduce your tax base through deflationary forces. In the case of Greece, they deserve to suffer from austerity policies as they were profligate. Ireland, on the other hand, was not and everyone is paying for the sins of overly leveraged, irresponsible banks that took advantage of their size to maximize risk and doing so while knowing the state would inevitably bail them out. Ireland will never be able to pay it back, not with an economy relegated to depression. Ireland should default, or just come close to it, so that Europe gives more favorable terms to a country that doesn't deserve what is happening to it.

No comments:

Post a Comment