The liquidity lie

We have been assured for two years this is a crisis of liquidity. It is not and never has been. But here is how those who claim it is come to their conclusion.

The model of growth I tried, possibly rather badly, to lay out in the post below “Cash, Debt and the Magic of Leverage”, is the key. The debt and leverage model is neat and powerful. Like gears on a car. It works. Cash buys debt, debt allows leverage and leverage allows growth far larger than can be achienced by any other means. All you need is for cash to flow freely around through debts and back again to be leveraged as more debt.

Now when cash starts to dry up, the whole model first slows, then stops – when no one can get a loan, and then if this condition persists starts to run backwards. From the point of view of those who have become rich thorugh debt and leverage the problem and its solution are glaringly simple. The problem is just that there is not enough cash. If there were then all the parts would work as they had been doing before. So, logically, the solution is to inject more cash – liquidity.

Their image is of a machine that has seized up and needs to be lubricated with liquidity. What this view steadfastly ignores, however, is the reason the liquidity/cash dried up in the first place. The cash stoped flowing because somewhere someone stoped getting payments coming in from their assets. They needed a loan to cover the short fall but the bank didn’t want to lend because, quite rightly, they could see the persons’ assets were not ‘performing’. Once the person failed to make payments on the loans he had taken to buy his now non-performing assets, then the bank who loaned him the money started to feel the shortfall of cash. The bank itself started to need a loan and so on.

If you flood this problem with cash what will happen? There will be easy money around. But will the banks use it to lend and lubricate the system as before? Well only if THEY BELIEVE that the loss of return on the non-performing’ assets is temporary. IF they do believe that then they will lend out the bail-out cash they have been given. But if they DON’T believe it, they will hoard the cash. They won’t loan it out because it would never come back to them. The person to whom they loaned it would pay off his creditors one time, and then continue to make a loss which would just require another loan.

If the banks suspect they are going to be faced with more customers not making payements. Then then bank is best served by keeping the cash to pay off its own loans since it knows it is not be going to be getting any income from those who owe it money. This is what our banks have chosen to do for the last two years.

In short, the liqiuidity argument ignores the one underlying aspect of greatest and defining importance – the evaporation of the underlying worth of the assets the whole upside down pyrmid is based on. That loss is what makes this a crisis of solvency not of liquidity. A permanent loss of value not a temporary constriction on cash flow.

Now the banks might just be honestly mistaken. Except what they say and what they have been doing contradict each other and this charitable interpretation. They have talked about this being a crisis of liquidity but their actions have said they actually know it is a crisis of solvency. If it really was liquidity the banks would have lent and be lending to each other. They have not ,aren’t and won’t. Because they know its solvency. They won’t lend to each other because they know the value of the assets each of them has to offer as collateral, is a tiny fraction of what they claim. They are not short of cash but of anything of real capital value.

What happened it 08 was that as the bubble market began to deflate the asset values evaporated. No one could get a loan because no bank would lend on the basis of ‘assets’ whose worth was declining day by day. This became a negative feed-back loop because the further the asset values declined the bigger the loans everyone needed and on the basis of less and less valuable assets. A very tight and vicious circle. Without collateral to post, no loans were forthcoming to cover interst payments. This was the collapse of interbank lending and the Repo market. First Bear Stearns and then AIG and Lehmans were killed by this mechanism.

We are there again NOW. We are not at the crisis point we were at with Lehman or AIG. Not yet. What is different and quite possibly more dangerous is that the problem is bigger and slower moving.

Cash and credit is tightening not only across the whole of Europe from Bulgaria to France and UK but also in China and Australia. In Europe interbank lending is a trickle. Most cash is having to come from the ECB. In China various banks that are desperate to raise cash by selling debt are having to scale back their plans because they know they won’t sell as much as they had planned and need. The short term boost to confidence this morning was that the market got the idea that the Chinese government would save the day by buying up whatever was needed. This is NOT a real solution.

Human’s are evolved to recognize danger when it moves fast. We are built to recognize a tiger running at us as a danger. Same with thrown stones. But imagine standing on a pier watching a super-tanker move very slowly towards the dock. Very slowly indeed. It does not occur to us as readily that we are in danger. We don’t really clock that the tanker will not be able to stop its huge momentum in time to avoid crashing. Its slow movement fools us, and we stay around oblivious and watch. Only at the last moment does it dawn on us that it isn’t going to stop. And only then do we look for the family to gather together and run.

And of course its too late and it can’t stop. Instead it ploughs slowly but unstopably on and on. Steel is crushed like it was paper and the ship just keeps coming. Its vast mass keeps it moving through everything in its path. That is our problem now. We are in a slow motion disaster. So slow we have still not relaized what is going on.

The tanker is debt. It is moving slowly but it will not be stopped now. We are all in its way. I really think you should find your family and do what you can to get out of the way.