Economic crisis - yet another post....

This is a post to explain the current economic mess from my perspective.

I've been following this economic crisis quite closely (not quite an obsession though) and in a nut-shell the whole mess can be described as an issue of "solvency -- not liquidity".

Solvency crisis = Business model is broken, unsustainable -- i.e. you cannot make a profit no matter what, with the current approach and strategy. Example: US car manufacturers (even when they make a small profit on cars, they give that all up funding pension/health plans). This crisis can only be solved with a change in culture/habit.

Liquidity crisis = This is more to do with cash-flow. Business is solid, but some payments are a little late (or) a sudden unexpected expense cropped up. Example: Fire gutted the warehouse, need an infusion of $100k to get over the next month before insurance claim comes through. This can be solved with a short-term loan.

The current economic crisis is mostly about 'solvency' of a lot of companies and entire sovereign states (Iceland -- UK potentially -- US most certainly) are spending way way more than they earn. They are covering for the short fall with 'credit' (borrowing from the future or other countries)

Unfortunately, the response from almost all governments has been to increase the credit limits so far -- as in they are acting as if it is a liquidity problem (for a whole lot of reasons which they argue are valid). They hold to the belief that all companies are solvent and are just going through a tough period. If we give them a life-line they will come out in good shape. A good example of this is the US car companies requesting money from the govt.

Making a company/state solvent would require deeper cultural changes -- which does take a longer period of time (potentially decades at the state level). Private enterprises that cannot get a govt. bail-out are pretty much doing this by cutting their expenses (salaries, new investments etc).

So what next?

1. The insolvent/inefficient/poorly-managed companies will die (if they were not hugely profitable in good times -- imagine their position now)
2. The companies that face sudden cash-flow issues are also in trouble because credit is harder to get now.
3. Companies that have been built/expanded with debt are in trouble. They have to re-pay the debt with reduced revenue.
4. Many people are being cautious and behaving differently -- they actually are moving towards saving before spending -- they are just questioning if they need yet another piece of plastic -- they are planning to keep their cars beyond 5 years -- they are looking at doing other activities beyond consumption of things.
   

This will all lead to loss of jobs in many sectors -- rippling out. The real question is -- "What if people want to live with less? If so ... is this a bad thing?".

Sadly governments will try to solve this problem by .....

• Cutting interest rates -- will not help if you are struggling to pay the principal
  
• Printing money -- nice in the short-term, but it comes back via inflation in the long term
• Extending credit to companies/banks -- will only work if you can actually make them profitable
• Cutting taxes - May help if you cut govt. expenses (i.e. cut jobs, spending). It will just move the pain around.
• Spending money - again great in the short-term to keep some people employed, but to date no entities has become wealthy by consuming and spending. And the worst part is most govt. get the money they spend via taxes now or in the future.
  

Is there a solution?
Free market economies are bottom-up organized systems. They are not directed and planned -- billions of micro-decisions made at the local level created our current economic system. Being a complex non-linear system -- simple acts like 'cutting taxes' etc. may or may not work. There is no way of knowing what the impact really will be. One thing is for certain -- the current mess took many many years to create and will take us a period of time to change the habits that caused this mess.

Now for the crux -- there is almost always a solution approach, but it depends on what has been framed as the problem. Almost all current solutions are being positioned to take us back a few years -- so we can live off credit and perpetual virtual growth. But, what if the existing model was the problem? and the current crisis is the start of a solution?


-- rv