What’s so bad about a liquidity crisis?

I’ve been trying to follow the news and commentary about the “bailout” and financial markets in some detail; but there must be some obvious background knowledge I’m missing. From watching bits of the congressional hearing yesterday, and reading the newspapers, it seems that the major purpose of the bailout is “restore liquidity to the markets”, which seems to be an economist’s synonym for “make sure the markets can still loan people money”.

What would happen if the markets stopped loaning people money? For consumers at least, there would be some short-term pain: people have been expecting to be able to use easy credit, so they haven’t saved money for a new car, Christmas presents, and so forth. The housing market would certainly change, and housing prices would drop even further because of a lack of buyers. But would that actually significantly disrupt the economy? Wouldn’t the population save their money for a few years, limp along with their old car, and then buy a new one with saved cash?

Presumably after all the existing bad securities are untangled, some banks will start to be able to loan money again, and these lenders will set stricter requirements on collateral and verified ability to repay loans.

Perhaps the consequences are more serious if business credit disappeared: capitalizing a new business or making capital improvements to an existing business pretty much requires credit. If we want to preserve this essential use of credit to keep the real economy strong (not the speculative market economy), isn’t there a way the U.S. government could guarantee this kind of credit for business capital loans much more cheaply than $700B, and let the chips fall where they might everywhere else?

I invite the blogosphere to link me up to classic economic treatises and modern articles which could help me understand how a liquidity crisis would cause the economy to simply collapse.

Atom Feed for Comments 14 Responses to “What’s so bad about a liquidity crisis?”

  1. Jarod Bishop Says:

    My thoughts exactly. We are being duped into thinking that maintaining this illusion of assets by large investment banks is crucial to the survival of our economy. OK, so the stock market drops some more. But eventually the companies, investment banks or otherwise, who are making sound financial decisions and investments will be rewarded by attracting more capital. All that money has to go somewhere, and the world pool of capital will always seek out new places in which to invest. The stock market will eventually go up, probably propelled by a different set of companies than now. Big deal.

    That’s capitalism. Let it work.

  2. Taras Says:

    Here is my ECON100 level view. Loans allow one to use future income sooner. This allows businesses to leverage future income to grow faster. Getting rid of loans would slow economic growth considerably.

  3. Jason Shindler Says:

    Here is what would happen:

    – If banks didn’t loan money, weak companies that are not doing well to begin with will not be able to make payroll, laying people off. This would increase unemployment, and further decrease consumer spending, which would lead to more companies that weren’t weak to begin with folding, increasing unemployment. This would spiral down, affecting even healthy companies.

    As an example, look at dayjet.com (www.dayjet.com) — a weak company in a weak industry.

    I’m still formulating my opinion and my philosophy on whether this or any bailout is a good idea. But this is a glimpse into the future if nothing is done and banks continue to struggle.


  4. mschaef Says:

    I wrote this on Reddit yesterday, and it’s still pretty much my understanding of why a collapse might happen:

    “If credit just vanishes with impunity, it could stop the operations of companies that depend on short term credit, regardless of their creditworthiness or the validity of their business model.

    Think about an entity that settles a market. Settlement means they write checks to net sellers and receive checks from net buyers. Short term credit is necessary to bridge the gap between outgoing and incoming payments. It’s also necessary if a buyer defaults. The lack of short term credit can make settling such a market much more difficult. This can include commodities markets: oil, natgas, power, etc.”

    There are the longer term concerns about business unable to expand and consumer purchases unable to be made, but there are also major categories of business that depend on credit to do what they do.

  5. Simon Says:

    This is a simple self-energizing effect:
    – If banks don’t loan money, companies will not invest in new machines, ventures, etc. which will cause job losses in those companies and also at companies, who sell all those machines.
    – Job losses mean that private households have less money to spend, which lead to even more job losses at stores and the companies that manufacture all the goods that those stores are selling

    Normally this will go to a certain point but no further because of opposing forces, e.g. cheaper work force, which would allow companies to make a profit, even though their business isn’t really going that well.

    What makes the current situation really bad is that banks now have a lot of assets in their balance sheet that nobody wants to buy. If nobody wants to buy your stuff, it’s worthless and accounting rules require that you value those assets as worthless. So now banks will have a large imbalance in their balance sheet, because all the debts they have are no longer countered by their now worthless assets, which will lead to them going bankrupt.

    One bank going down isn’t that bad, because there are mechanisms in place to ensure that everyone who had money at that bank would get it back (mostly) but right now this balance sheet imbalance is happening to a lot of banks in the US and all around the globe. So this can easily turn into a domino effect where one bank after another collapses, which is impossible to bolster. Then we will have lots of people who had their savings deposited in those now bankrupt banks, which means that their savings are gone and they have no more or at least less money to spend. For the effects, see above.

    In the end we would see 1929 all over again, a depression, not a simple recession. For more explanation, see wikipedia.

  6. Ian McKellar Says:

    My understanding is that large parts of US GDP is through consumer spending, and large amounts of that is via credit. So a consumer credit crunch would screw everyone from WalMart through to Mozilla (since MoCo revenue is indirectly advertising revenue). Having said that, a little tough medicine would probably be good. If there’s structural change that needs to take place and leadership hasn’t been coming from government or industry leaders then perhaps it’s time to let the market do what it does best :)

  7. Sebastian Says:

    There is an additional aspect you didn’t mention. If people start to save money so they can do investments again, people will spend less money for some time, which would lower national consumption. This is where part of the problem lies, because lower consumption destroys jobs.

    The problem: It’s absolutely crazy to have an economy that is based on people taking loans for bigger investments. A high percentage of big investments in the US are financed through loans, and it would be necessary to change that.

    But: Any quick change will damage poor people. In the US, being poor is already difficult enough, it would definitely make life even more difficult for them, lowering prospects of escaping poverty, etc. That’s capitalism as it works, but it’s definitely not humane.

  8. guanxi Says:

    You might have heard the expression, “in the long run we are all dead”. It was coined by John Maynard Keynes, one of the few greatest economists in history, who said:

    “… this ‘long run’ is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”

    The idea of letting the market sort out the problem ‘in the long run’ is what he was referring to. Doing so would consign millions, maybe billions, to misery — unemployment, malnutrition, and a society set back a generation — for example, who will pay for green technologies if they can’t feed their families? Who will pay for college? Who will fund non-profit software organizations? In poorer parts of the world (which would be swept up in our collapse), there would be starvation, chaos and war. We set the bar too low if we say, ‘in the long run’ it will be ok.

  9. guanxi Says:

    “It’s absolutely crazy to have an economy that is based on people taking loans for bigger investments. A high percentage of big investments in the US are financed through loans, and it would be necessary to change that.”

    It’s not crazy, it’s a necessary and very efficient way to run a modern economy. Without it, we would all be much, much poorer. Think of debt this way: If I’ve saved $100,000 and it’s sitting in my piggy bank, and you need $100,000 to start your software business, isn’t it much more efficient for you to use the money for something productive than for it to sit there unused? So I loan you the $100K, you use it to generate $200K in revenue, give me back my $100K plus $25K extra in interest. Now I have a $125K, you have a software business and $75K in profit, your employees have jobs, and your customers are more productive because they have your cool software. Isn’t that better than if I left the $100K sitting in my piggy bank, doing nothing?

  10. Boris Says:

    Liquidity is not only about loaning people money but also about being able to pay off your obligations (including, say, redeem bank deposits on demand). I suspect that a lot of what’s going on is effectively an attempt to prevent a run on banks, money market accounts and mutual funds, and so forth…

    But I’m not an economist, so I might be misunderstanding things.

  11. quodlibetor Says:

    One thing that you might not know/remember is that liquidity refers not only to the ability to move money around, it is also used to euphemistically refer to a person or business’s ability to pay off it’s debts. I’m pretty sure the secondary, not-particularly common definition is what they’re talking about.

    Right now lots of the world’s largest banks are close to broke, and if they go broke then *everybody’s money disappears*. And there are way, *way* too many of them nearly broke right now for FDIC to be able to really handle. Also the crisis is international, and i’m not sure what other countries have got in place to deal with this kind of thing. And also, perhaps even more importantly, FDIC is basically meaningless to businesses with their money in banks. I’m sure mozilla doesn’t keep their money under a mattress, if your bank folds, mozilla’s 75 (or whatever) million completely dissapears. That is a problem not only for small companies.

    Also, if i remember my old econ classes, the whole stock market is basically just people playing with banks’ money: it’s individual people saying “here bank, borrow this money of mine and let use it for whatever they want, but give me some ROI if they do well.” Since that money goes to banks, companies that have most of their money from their stock are in even more trouble than companies with only savings invested in banks.

    The euphemistic definition of liquidity comes, i’m pretty sure, comes also from the fact that banks have got to be liquid enough with their money to be able to give it to their clients when they ask for it. When you put your money in the bank you are effectively loaning it to them, they are your debtor, if they can’t pay off their debts, they can’t pay /you/.

  12. Mike Beltzner Says:

    The basic idea goes back to ancient Egypt and the concept of a granary. It’s impossible to fully predict market conditions, and thus businesses will always suffer unexpected slow months, or be unable to meet an onslaught of demand. The way around this is to build up a store of assets (grain, money, capital) and dispense them in order to smooth out the bumps of boom and bust times. In modern financial terms, the credit market provides this capital granary; companies who find themselves in need of quick growth or of some help in an unexpected slow down can use credit to smooth over the fact that they don’t have funds to hand. This also allows them to invest the funds they do have in new assets, etc. When access to credit is hard, growth and security is harder and companies will fail.

    Mortgages are obviously involved in this, as it is the speculation on the debt markets (and their constant repackaging and sale to the point where good mortgages were indistinguishably lopped in with bad ones) which caused the banks to over-estimate the amount of return on their security-backings and get into this mess. The bailouts are the government applying the granary concept again, though this time they’re borrowing against the future — adding deficit on the premise that if we make it through this, we’ll generate enough money to repay those federal debts.

    Good thing you don’t also have a war bill or lingering pension and medicare crisis on the books for the future … oh, wait.

  13. Jay K Says:

    Ron Paul has some insight, of course: http://www.dailypaul.com/node/64116

  14. Jason Orendorff Says:

    Heh, I totally missed this at the time. All these comments must have been astoundingly unhelpful!

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