Insolvent - who's insolvent?

In 2000, the IMF added up the reported trade balances for every country in the world and discovered that total world imports were $172 billion greater than total exports. Discounting the prospect that aliens are using their unfair price advantage (presumably they are not subject to payroll taxes) to steal our jobs, the idea that the world as a whole could run a trade deficit is of course absurd.

However, the idea is resurfacing in much recent comment about the world financial crisis. Even the excellent Martin Wolf is talking about "a growing crisis of insolvency" and this is becoming a common theme: we thought we had an illiquidity problem, but now we find it's an insolvency problem.

Well, it's not. Insolvency is the inability to pay debts as they fall due. The total amount of debt in the world is zero - every debt is owed by one party to another party, in equal amounts. Just like the total trade balance of the world is zero, the world does not have any debt and therefore cannot be insolvent.

Of course, individual institutions can be insolvent - as can, conceivably, a whole collection of institutions such as the financial sector. And this certainly causes problems. But let's not pretend that somehow the whole world has fallen into a black hole of debt which needs to be filled by printing money.

Money and debt are just ways of making a claim on someone else's future work or resources. These claims are a useful tool in coordinating the use of resources to make us all happier. But no amount of debt (or money) can in itself create or destroy the productive use of resource. Ronald Coase showed that (apart from transaction costs) the actual ownership of resources is irrelevant in determining the most efficient way to allocate them to produce economic output. The expansion of debt - or default on it - therefore causes no economic problem in itself.

The public sector interventions (OK, I'll let you call them bailouts) are presented by some as an expensive use of public resources to somehow fix an insolvent economy. But if the economy is not insolvent, all they are actually doing is transferring a set of claims from one party to another. It is likely that this will vastly reduce transaction costs - imagine 300,000 Icesave depositors all individually pursuing Icesave's creditors through the courts - but, in reality, it actually doesn't cost anything. The only issues are: (1) the extent to which we lose the useful tools that are embodied in monetary incentives and (2) the equity of resource allocation in the resulting system.

Therefore, look at these bailouts as cutting the Gordian (or Gordian Brownian) knot of complex financial transactions; and potentially, a way of reallocating resources in a fairer way. But don't lose sight of the valuable knowledge embodied in that knot. The ties of debt, obligation and payments that kept flowing through our hugely complex financial system until a few weeks ago are a brilliant collective invention, one that helped us all to get 50% richer over the last ten years by using our resources more cleverly. We need to allow complexity to exist in our lives in order to live better.


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