How to make the difference between a crisis of solvency and a crisis of liquidity?
The difference between a crisis of liquidity and a crisis of solvency
can appear rather technical and in the end not very decisive concerning
the evolution of the current crisis. However it is not a simple
academic dispute; indeed, according to the answer to that question, the
actions taken by governments and central banks will either be useful or
utterly useless, if not dangerous.
A simple example can help to
understand what is at stake. If you meet a temporary problem of cash,
and if your bank or your family agrees to lend you the money you need
to cross over that difficult path, their effort is mutually beneficial.
Indeed, you can resume your activity, you can pay your employees and
yourself, your bank or your family get their money back (with an
interest in the case of the bank), and the economy in general benefited
from a positive contribution. But if your problem is not due to a
question of cash-flow but to the fact that your activity has ceased to
be profitable and will never be again because of new economic
conditions, then the effort made by your bank or family becomes all the
more dangerous that it was substantial. Indeed, in all likelihood, your
first call for funds will soon be followed by more calls, always
matched with promises (honest ones we suppose) that difficult times are
about to be over. The more your bank or your family has lent you (and
therefore the more it would lose if your activity is stopped) the more
willing they will be to continue helping you. However if the situation
worsens, and it will if it comes from a problem of profitability, there
is a moment when the limits are reached: on the one hand, your bank
will decide that there is more to lose in keeping supporting you than
in letting you down; on the other hand, your family ends up with no
money left because you have siphoned its entire savings. Then it
appears clearly to everyone not only that you are insolvent or
bankrupt, but that you dragged down with you your family or your bank
(4). You have thus dealt a severe blow on the economy around you,
including on your close relatives (5). It is important to highlight the
fact that all this could take place in all sincerity because you were
not aware of the impact on your activity of a sudden change in the
economic context disrupting the conditions of your profitability.