Stiglitz, Joseph Making Globalization Work, WW Norton 2006.
Reflections from Europe | JANUARY 7, 2008
Solvency and Liquidity: Some Financial "Crises" Are More Critical Than Others
Recently, Professor Stiglitz accused the financial powers-that-be of hypocrisy2 for prescribing bitter medicine to the poor when a financial crisis hits them, but treating the rich with the greatest mansuetude when they get into similar trouble. He recalled the draconian measures the IMF imposed upon poor developing countries during the 1997 Asian financial crisis and indignantly compared them with the generous flood of money with which the world's major central banks inundated the banking systems of the rich Western world in 2007. One justice for the rich, another for the poor.
It is an elementary but still useful exercise to sort out the two fundamental variables, solvency and liquidity that, albeit in different proportions underlie any financial up set.
Solvency is an attribute of a person, firm or state and in its perfect form signifies their ability to discharge any of their obligations on the date it falls due. It means that the debtor has sufficient assets in cash or in such other forms that can with virtual certainty converted into cash by the due date. When sufficient assets are available, but in such forms that converting them into cash on reasonable terms takes longer than required, we may speak of imperfect solvency or temporal insolvency. Temporal insolvency has a probability distribution of the dates on which the asset will be converted into cash for instance, there may be some probability that it will be sold and the settlement take place within a month after it is put on the market, with the remaining probability being that this will happen within three months. At all events, these contingencies are different from absolute insolvency, when the debtor simply lacks sufficient assets in any form, or when the probability of converting them into cash is very small or very remote in time.
Liquidity is an attribute of assets (though one does say that a firm is very liquid when much of its assets are in cash or quasi-cash). It signifies that the asset has a market with several active or potential participants, and can be instantaneously converted into cash at or just under the market price, or can be bought for cash at or just above the market price. The price at which a buyer will come forth is the Bid and the price to bring forth a seller is the Ask. The measure of liquidity is the inverse of the spread between Bid and Ask. A $100 bill can be sold for $100 and also bought for $100; the Bid-Ask spread is zero and the bill's liquidity is perfect. A widely held share may have a Bid-Ask spread of one-sixteenth of a dollar, a less active one a quarter. Exotic securities may trade at spreads of five per cent or more, used cars or second-hand machine tools at thirty or fifty or indeed at almost any spread into which a clever buyer can talk a hapless seller. They are "liquid" in a strict sense, though it is not reasonable to regard them as liquid. (This is one of the numberless cases where it is reasonable to use the vague word "reasonable", for nothing more precise will suit the case). Information about the asset will heavily impact on its Bid-Ask spread. The used car, like the pig in a poke, may be very illiquid because too little is known about it. Liquidity, like solvency, also has a temporal dimension: the Bid-Ask spread will normally be highest when sale and settlement must be instantaneous, and will narrow down if the asset can be left in the market for short, medium or longish periods. Here is one area where solvency and liquidity shade into one another at their margins.
Now we may briefly consider some of Professor Stiglitz's charges. By the time the 1997 crisis set in, certain Asian countries got themselves heavily into short term debt, some of it "hot" money ready to move in or out at electronic speed. Typically, local banks borrowed from Western ones at interbank rates and re-lent the funds to local business which put them into inventories and equipment. The accompanying balance of payment deficit and other signs of overheating then reached a critical point at which all the Western lenders tried to get their money out again. There was at least temporal insolvency, for assets located in Asian countries could not be converted into foreign currency unless long-term foreign capital was streaming into the country. Manifestly, the contrary was the case. An Indonesian timber logging concession did not attract a single foreign bidder at two year's purchase. The IMF had to step in and bail out the Asian countries. The alternative was default and shambles on the 1998 Russian model. It is worth remarking that the Asian countries had positively asked for the IMF to bail them out, and knew the conditions—fiscal austerity, monetary squeeze—they had to accept to get it. Perhaps they should have chosen to default, like Argentina, but that is an entirely different question.
For more on international capital movements and the IMF, see "Capital Flight", by Darryl McLeod, in the Concise Encyclopedia of Economics.
Professor Stiglitz points out that two countries, China and India, remained untouched by the crisis and these were the two countries who had resisted the liberal doctrine and kept controls over capital movements. Now it is true that capital controls should be used when necessary; the word necessary tautologically means that this is so. The trouble is that when they become "necessary", it is too late to slap them on. While if they are kept on permanently, they occasion very high permanent costs. They frighten off the inflow of foreign investment. They also cause a trickle of capital outflows by using a variety of devices that nobody has yet found the means to stop. On the whole, liberalisation of capital movements seems the better bet. Professor Stiglitz may also be reminded that China and India had truly miserable economies as long as, true to the spirit of Mao in China and the Nehru dynasty in India, they clung to socialists controls and regulations, and did not "take off" until they had begun to scrap them. It is hard to believe that capital controls are the one exception that must not be scrapped.
While the Asian, Russian and Argentine crises were crises of solvency, the Western financial crisis of 2007-08 is a crisis of liquidity. It is different in kind, and also less critical. It sprang from two sources. One was a bout of perfectly commonplace over lending in the American residential mortgage market. Too many mortgages were written for nearly the full value of houses owned by residents with too low and precarious incomes. Once house prices peaked and started mildly to decline, many of these mortgages were no longer serviced and foreclosure involving heavy loss, or patient waiting for better days, were the lenders' only options. However, all this was, so to speak, in a day's work.
The second source of the crisis that, combined with the first, made an unstable mixture was feverish financial innovation. Two devices proved particularly fragile. One was the creation of "collateralised debt obligations" or CDOs. They gathered essentially illiquid assets, such as residential mortgages, into packages serving as collateral for securities of various yields, maturity dates and risk profiles. Thus a vast potential market was opened for relatively illiquid assets rendered liquid by presenting them as securities suitable for financial investors seeking particular yields, maturities and risks. This was undoubtedly a sensible innovation doing good for mortgagors, mortgagees and third-party investors alike. However, when some mortgages within the collateral package started to turn sour, the CDO would turn to poison, for nobody wanted to hold paper whose quality suddenly proved to be quite uncertain. Lack of adequate information bred suspicion and turned hitherto liquid securities into illiquid ones, unwanted and hard to trade.
All this was exacerbated by another innovative device, the "structured investment vehicle" or SIV which borrows in the money market and invests the money in higher-yielding securities, including about 55-60 per cent in CDOs. When CDOs are suspect, SIVs become suspect and so do the banks which sponsored them or granted them borrowing facilities as a second line of defence.
For more on the role of central banks and how they respond to liquidity crises, see "Federal Reserve System", by Manuel H. Johnson, in the Concise Encyclopedia of Economics.
At the core of this crisis, there is a relatively small dose of insolvency originating in the mortgage market. The layered structure of a highly developed financial system magnifies the effect of a small rotten core by what looks like a double-digit factor. Most of the damage is in the eye of the beholder. If, under such circumstances, losses had to be cut by selling assets that have fallen under suspicion, much damage that is now merely virtual would become real, thus exposing the banking system to needless shock and causing an arbitrary redistribution of wealth in favour of "vultures" of all kinds.
It is, then, not "hypocrisy" nor partiality for the rich Western countries that makes central banks try and keep interest rates low and pump unprecedented volumes of money into the banking system, but good sense. The crisis needs to be digested, suspicions allayed, adequate information provided and when that is all done, liquidity will be found to have been restored.