Thursday, October 09, 2008

The Rate Cut Is No Fix

The headline in today's Trib screams, "Rate cut won't be a quick fix." I beg to differ. It won't be any kind of a fix. Time for a lesson every business owner should sit through: the difference between liquidity and solvency.

A rate cut reduces the cost of money and encourages people to borrow. This would be a fix if the problem were lack of demand, but that isn't the problem. There's plenty of demand, but people can't find credit.

So the problem must be supply, right? And you encourage supply by encouraging lenders to lend more, such as by providing them with cheap capital to land and guaranteeing their loans (Which is what the recent bailout does, except it goes a step farther and says, "We'll guarantee you loans no matter how idiotic they are." Also, the federal government, by encouraging both demand and supply, is now moving in opposite directions simultaneously, which should surprise no one.). But the problem isn't supply, at least not that kind of supply. The problem isn't that the supply is there but the pump needs primed to get it flowing so everything can get back on track.

The problem isn't liquidity. The problem isn't that the system is strapped until pay day and needs something to cover until then. The problem is solvency: There aren't enough assets to cover the liabilities. The only way you can get a lender to bring more to the table in those circumstances (to allow you to increase your liabilities) is to bring more assets. And we're talking about hard assets, not IOUs and other paper.

For example, my cousins in Iceland have ridden the finance boom like Viking raiders. Unfortunately, the longship has sprung a leak, and they might not be able to bail fast enough. Iceland's three main banks are all in trouble, and the government shut one of them down yesterday. Personally, I think they're going to have to go back to herding sheep and eating rotten shark for a couple of generations, but in the mean time they're desperately trying to maintain the status quo. They've even asked Russia for money, but Russia wants real assets, not paper. Iceland has offered the old, US airbase at Keflavik. Think a bit about the irony of that one. But that's the way it will be, even for the US. In order to increase our liabilities (budget deficit, trade deficit), we shall have to give up assets (land, factories, companies). That's the difference between being illiquid and being insolvent. You can paper over illiquidity, remain intact, and move on. If you are insolvent, people will take pieces of you until there is no more you.

Liquidity problems are short term. There is no such thing as long term illiquidity (Back to the Trib headline. If the rate cut doesn't solve things quickly, it won't solve things at all, because the problem isn't liquidity.). If you are constantly borrowing to cover operating costs, your problem isn't illiquidity but pending (or existing) insolvency, and if you don't correct it right away, you're spinning in.

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