Liquidity or solvency?

Danske Bank raises a relevant question on the subprime problem: is it a liquidity or a solvency crisis? Clearly, Central banks have added liquidity, helping to un-block money markets. However, risk premiums re-main substantial

Danske does not know how monetary authorities around the world will handle the crisis going forward. For them: “The US markets price three rate cuts by December, and further cuts in 2008. The FED has acknowledged a more downbeat outlook, but it remains to be seen whether it will deliver (next meeting on September 18). The ECB has been unwilling to pre-commit to anything ahead of the September 6 meeting, referring instead to its August 2 statement. “

The main question posed by Danske is whether the problem relies mainly on liquidity (and then the strategy of monetary easing is the right one) or if the issue is one related to the solvency of the financial system. Indeed, problems related to financial system solvency are issues that relates to Central Banks responsibility.

Danske seems to suggest that the subprime crisis may be more related to solvency than to liquidity. This is so because the crisis strikes the US housing market, suggesting serious implications for consumer spending. In their view, the crisis unfolding is a by-product of tight monetary conditions during the past years. The massive monetary expansion since 2003 has been slowing turning as policy rates have increased. Indeed, G-10 Central Banks have increased rates to fight inflationary pressures.

While we all acknowledge that financial crisis happen when there is a shortage of liquidity, the issue at stake is what happens next? In their view, the most likely scenario is for FED to cut rates in line with the market while other central banks deliver moderate interest rate cuts. Danske however also argues that it is still unknown if the ECB will pause in September and increase rates in October.