Our Fairy Tale Economy


Anyone who has children is familiar with the concept of re-living their childhood.  From introducing my kids to Star Wars, to teaching them to throw a baseball and ride a bike – all of these bring back fond memories of years long since passed.

One activity that I particularly enjoy is reading the old Aesop’s Fables and the Brothers Grimm fairy tales to the kids.  I like them because, unlike some of their more modern counterparts that show up in slickly-designed animated movies, the children’s stories of old were designed to teach a particular moral lesson and…they usually did not have happy endings.

My particular favorite is the Tortoise and the Hare…..which sort of reminds me of today’s economics….

“This Bechara is a basket case!” screeches the peanut gallery. “First he admits that he likes these depressing fairy tales and then he goes off the deep end by likening them to economics!”

Anyway, the perceptive amongst us realize there is a battle raging in our economy and to us it seems that the wrong side is prevailing.

No my friends, I am not talking about the inflation vs. deflation argument.  That is an output, or a symptom, of the economic policies that a nation chooses.  Time will tell us of which fruit we will partake, as our economic choices aggregate to produce one or the other.

What I am talking about, are the inputs or contributors that will shape the final outcome.  For the other more important battle is being fought between solvency and liquidity.

Many confuse the terms and use them interchangeably but the basic definitions are:

Solvency = Assets exceed liabilities (i.e. you can meet your long term obligations).
Liquidity = You have enough cash to pay your present bills.

Mr. Liquidity is the Hare: Well dressed, fast moving and fast talking.  Only concerned with the present, he likes to eat sweets and other simple sugars that give him a quick rush.  He is often found ogling the latest Statement of Cash Flows.

Mr. Solvency is the Tortoise: Plainly dressed, slow and methodical.  He is obsessed with the long term and prefers proteins and other foods that provide long term energy.  He eyes the Balance Sheet obsessively.

For now it looks as if Liquidity has won.

Since the crash of 2008, we papered over our insolvencies on the personal, corporate and governmental level with additional liquidity.  Stated simply, we have tried to solve a problem of too much debt by…taking on more debt.

Our society is weighed down with debts that have almost no chance of being repaid.  A classic case of insolvency.

But rather than taking the right medicine for the right disease (i.e. going through a process of default, deflation and debt destruction via the bankruptcy courts), we have chosen to provide “more liquidity” in the form of more debt.  This concept is illustrated beautifully in this chart provided by The Market Ticker:

 

For those in the peanut gallery, if you are insolvent and someone gives you more cash (liquidity) in the form of more debt to make your interest payments, that simply makes you….more insolvent.

Furthermore folks, we are in a zero interest rate environment, or in Fed speak, ZIRP.  For those concerned with risk management, this has rendered the very concept of prudent financial management moot.

For whatever corporations, households or governments do to disfigure, vandalize and maim their balance sheets, there seems to be always another sugar high, another liquidity injection, another subsidy to keep them going for another few months.

The era of the zombie balance sheet has arrived.  It looks dead ……but it’s still in business!

What about Mr. Solvency?  Currently he is embarrassingly out of fashion.  He is jeered at, called names, and told to join the party…some corporate managers are even self conscious about being seen with him.

None of this bothers Solvency.  He has seen this all before and has witnessed the countless bubbles, follies and denials of fact throughout economic history.  In fact, Mr. Solvency and his friend, Mr. Bond Market, usually have a rendezvous at the end of these time periods.

So how will this play out?  Does the party continue forever?

Typically, all three of these characters meet near the finish line.  The fast moving Mr. Liquidity runs right into Mr. Bond Market ……and promptly has a heart attack.  While Mr. Solvency passes by with a knowing nod to the Bond Market.

We have not yet neared the finish line and the spectators lined up along the raceway continue their merciless heckling of Mr. Solvency.  But he stoically plods onward to the rendezvous point, watching the balance sheet and shaking his head in disgust.

Sooner or later my friends, the Fed will take away the punchbowl, whether voluntarily or whether it’s snatched away by the bond market.  At that time the liquidity transfusions into the zombie balance sheets will cease…with very predictable results.

Seasoned financial managers know that you can ignore systemic risk, disregard macroeconomic trends and trash your balance sheet…..but sooner or later the Hare crashes down off his sugar high and the methodical, well balanced, risk aware Tortoise… wins the race.

Have a great week,

Michael Bechara, CPA
Managing Director
Granite Consulting Group Inc.
mbechara@consultgranite.com
www.consultgranite.com

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