Why Credit Matters

Friend of the blog Jeff Alworth posed a challenge in the comments: can you explain what's at stake in the credit crisis for the average "person on the street." I started to write a response but it quickly turned into the now well-worn "credit dries up, housing market gets even worse, recession, unemployment, etc." and realized that I wasn't really helping. So I am going to try a new tack: explaining in simple terms (sorry, econ majors, bear with me) why credit matters so much to the economy.

So let's start with the observation that healthy economies keep money circulating - the more it moves around the more it can be put to productive uses. Consider the simple, stylized example that often starts a money and banking course. A person saving for retirement wants to make sure there will be enough money available to them to live on in the future. So they start to stockpile cash in their mattress. At the same time, someone else has a great idea for a new business, one that could make a time saving device for all to benefit from and that would employ many people in its manufacture.  Problem is, this person does not have enough money to start making the devices but knows that if she could borrow it, her business would be successful enough to repay it many times over.  Could each person be made better off than the current stalemate of money in the mattress and insufficient funds to make the time-saving device?  Of course!  The saver could end up with more money to live on in retirement if they could loan it with interest and the borrower would happily pay interest in order to see her business get off the ground.  [NB: We economists call this a Pareto improving exchange as both parties are made better off and no one is worse off]

The problem is of course that the saver may never know the borrower exists, so even though they both would like to make this exchange, they cannot.  This is where banks and other financial intermediaries come in, they help facilitate the exchange. In fact, banks simply offer interest if you deposit money with them, they don't make you wait to be paired up with a borrower.  They go out and look for borrowers and charge them a higher rate than they pay to borrowers and the difference is how they make money.  And why not, it is a valuable service to both parties.  It is also a valuable service to society because now lots of entrepreneurs can find money to start up new businesses and these businesses employ workers, pay taxes and potentially make life better for the consumers of their products.  

But we still haven't left Bedford Falls where the building and loan collects locals deposits and lends them out as mortgages.  Now let's move to the bigger world of banking finance.  In the modern banking system banks on a daily basis have surpluses and shortages as money flows rapidly and hundreds of thousands of deposits and loans are accounted for.  The money that comes from savers now comes from around the world and is loaned out around the worlds too, though much of the worlds savings has been spent, recently, by US consumers.   To keep all of this money flowing to its most productive uses, banks regularly borrow and lend from and to each other.  And just like us little people, they too pay and charge interest rates.  And the problem right now is that this lending has essentially seized up, leaving banks high and dry when they are trying to raise some liquidity to lend in order to make some money to counter the quickly sinking assets they have on their balance sheet (largely mortgage backed securities).   Without this ability to raise capital, banks are in danger of collapsing (e.g. WaMu).  To see for yourself, look at the TED spread which is the difference in a measure of bank-to-bank interest rates and the rate in the T-Bill.  If you are a bank with some excess capital on your books and you want to earn money rather than having that money in your mattress (so to speak) you can invest it in the safest instrument around (the T-Bill) or you can lend it to another bank.  This second option is not as safe because there is a higher probability that you might not get paid back, and thus bank-to-bank interest rates are always a little bit higher - until now.  Now they have gone through the roof.  This is the purest snapshot of the trouble the credit market is in at the moment.

So it all maters to you.  In the wide world of banking, these intermediaries are like the fuel pump to an economy, constantly pumping the fuel (credit or other people's savings) to where it is most combustible, to the most productive uses. By so doing, it really keeps the engine of the economy running, it keeps existing businesses going, new businesses starting and consumers able to consume. So credit really is the fuel for the engine of an economy. In my work as a development economist, we often finger the credit markets (or lack thereof) as a major obstacle to growth in low income countries. 

What I would expect the 'person in the street' to see, if banks are allowed to fail is a drying up of credit for things like houses, education and consumer loans.  I expect to see a spike in unemployment, a further and perhaps much more dramatic fall in the residential housing market and a significant slowing of economic growth and probably negative growth for some time.  This all hurts.  Tax revenues will suffer, so state services will be diminished.  Jobs will be harder to come by and the ability to smooth consumption spending will be curtailed by the lack of credit.  

  

So it is not the big CEOs of these banks that will suffer if the banking system is allowed to collapse (they are incredibly wealthy already, they'll be fine), but the most vulnerable in society that will suffer.  I, for one, hope the bill is passed very soon.

Incidentally, my big concern is if $700 Billion is enough.  I think that the probability that the US will take a big loss on these assets goes down the bigger is the bailout.  That's because the US is hoping that this temporary hysteria in the credit market is what has collapsed the price of these mortgage backed securities, not that they really are worthless.  The likelihood that these will return to a reasonable price is greater the greater is the bailout (the healthier the banks become and the more money is put back into housing - the fundamental asset behind these securities).  

Fingers are crossed for tomorrow...