Is the Problem Liquidity or Insolvency?

Martin Wolf is an economist who writes a regular column for the Financial Times.  If you don’t read him you should because he is what I call a “fog cutter”; he is very good at putting a subject in perspective. 

 You can read his latest column by clicking here.

 Wolf contrasts two very different views of the bank problem.

 First, is the view that the problem is one of liquidity.  That is, so-called toxic assets are selling below their long-term value and may be difficult to sell. The answer therefore is to provide a market, buy assets or guarantee them.  This what the TARP was supposed to do.

 The other view is that the problem is insolvency.  That is, banks’ assets are less than the liabilities. Given that the steep economic plunge is still in progress, and that serious problems with credit card debt, business loans, commercial real estate mortgages, leveraged buyout debt, and sovereign debt of countries in areas such as Eastern Europe may be just beginning, I lean to this second view.

If the insolvency view is correct, then, as Wolf writes,

The correct advice remains the one the US gave the Japanese and others during the 1990s: admit reality, restructure banks and, above all, slay zombie institutions at once. It is an important, but secondary, question whether the right answer is to create new “good banks”, leaving old bad banks to perish, or new “bad banks”, leaving cleansed old banks to survive. I also am inclined to the former, because the culture of the old banks seems so toxic.”

In any event, as Geithner said, it’s important that we get this right.  But yesterday’s (2/10/09) “plan” did not instill confidence. The consequences of screwing it up are very serious indeed.

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