If you watch economic news in either TV or the internet, you often hear liquidity issue and solvency issue. Specifically, many news commentators were saying 2008 financial crisis was due to liquidity issue but this coming European debt crisis is based on solvency issue. So, what is the difference between those two? I believe that understanding difference between two is critical in order to grasp what is going on in this economy as well as what to prepare. In this blog, I would like to explain these two difference in very simple term.
Let's take a look at liquidity issue first. Basically, liquidity issue is that people do have ability to pay but not enough cash (or equivalent) at that time to pay to the creditors.
Below is the example of liquidity issue. You have enough long term assets that can convert into cash to pay the obligation to the creditors. However, there is no cash on hand to pay to the creditor at this moment. In this case, it does make some sense to borrow the short term cash from some other sources to pay off current obligation.
On the other hands, solvency issue is much much more serious that the liquidity issue. People have no way to pay back to the creditors because total obligation is far greater than the asset they own. Does this sound familiar to you? If so, then you get my point. This is the exact situation of the major industrialized nations around the world, including but not limited to US, Eurozone and Japan. In this situation, borrowing from some other sources to pay off the old obligation does not solve underlying structural problem because it is mathematically impossible for them to ever pay off the debt they owe. Simply, they are just kicking the can down the road. Unfortunately, this is what our leaders are doing. Remember my previous blog (US Fiscal Condition in a nutshell), average household is earning $46,000 but their expense is $76,000 and worse, they owe $581,000 in credit card debt. This is exact financial picture of US government.
Because of media saying European sovereign debt crisis unfolding, I heard many people are trying to hold US treasury for the safety. But, considering basic explanation with chart like above, holding US treasury or any government bonds is real answer? I really don't think so. In fact, owning government bonds is the riskiest thing we can do in this current time. Like US situation above, What government and central bank will do is to borrow more to pay off the old debt (Kicking the can down the road). Therefore, more and more money will be created out of thin air. This is the core reason why I buy gold and silver. As long as our leaders do this, price of gold and silver is going way up.
P.S: I wrote new article about greatest wealth transfer. This entails what's happening in world economy in greater detail.
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Published: 13 October 2011