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.

The Irish Financial Crisis Becomes a Political Crisis

http://www.nytimes.com/2010/11/23/world/europe/23ireland.html?_r=1

This has been an ongoing concern of mine for most of the European debt crisis. First, universal austerity simply does not work as a strategy for dealing with massive debt levels as its deflationary influence essentially digs the hole deeper as you are trying to get out. Secondly, it's politically damaging considering that it will coincide with a severe economic crisis. Ireland is in the midst of what can only be described as a depression and that will not correct anytime soon. In fact, it will get much much worse considering the magnitude of their fiscal contraction. The incumbent government will lose the next national election considering that the prime minister has a whopping 11% approval rating from the last poll I saw. Frankly, they should lose given that they have been in power for the boom and now the collapse.

This really is an issue where many Irish sense that their nationally sovereignty is at risk in these bailout agreements. At the same time, they really don't have a choice, but then again neither does Europe. The EU cannot allow Ireland and its banks to fail due to the collateral damage. It will be interesting if Ireland decides to take the approach that they will limit what austerity measures they put in place because they realize their importance to European financial stability. In the long run, Ireland's economic situation will get so bad that it risks severe political instability of the sort that we haven't seen in a while in most developed countries. They already have a 14.1% unemployment rate and that will not get better with the austerity measures being proposed.

As far as the EU's approach on all of this, I am doubtful of its long term viability. Basically, Germany and France are on the verge of backstopping Greece, Ireland, and then Portugal and Spain. If and when Spain becomes part of the mix, I really don't know that they are good for the money. At the same time, they are pursuing deeply deflationary policies which pose a particular problem in the context of a deflating asset bubble. The deflating real estate prices in Ireland, the UK and Spain are one of the major causes of the ongoing banking problems and austerity will only contribute to further deflation of those prices. As this pain continues, it will be difficult for governments to maintain policies of retrenchment.

Frankly, there is a serious risk that Europe is entering a deflationary spiral of a fairly severe magnitude, which will invariably lead to continued political instability.