Plain Sense Economics

My head’s spinning with all of the once-in-a-lifetime monetary policy and other government action going on. Even so, this is a good moment to stop and review, in simple terms, what kind of problems the Federal Reserve and the Treasury Department are dealing with and what steps they are taking. …very simple terms…

Liquidity / Credit Crisis: The main cloud hanging over our economy at the moment is the inability, or more accurately, the unwillingness of banks and other financial institutions to loan money – hence the label “credit crisis”. This has happened for a number of reasons. I’ll mention a couple.

1. Banks and other financial companies saw their assets disappear in rapid, unexpected fashion. As we’ve learned throughout the year, many financial institutions had been buying, for investment purposes, securities made up of mortgages on people’s homes. A couple of years ago these packages of 1000s of mortgages were judged to be quite safe. Even if a percentage of those mortgages went into foreclosure, the rest would be fine and the whole package would be fine. However, when the housing price bubble burst and when some loans with very low interest rates and monthly payments reverted to more normal levels, the rate of foreclosures escalated. Now those packages of mortgages started looking less safe, and banks and others started trying to sell them and bail out. Those packages were recorded on the banks’ books with a certain value, but that value started plummeting, as it got harder to find buyers for these packages. Banks started seeing their net worth disappear overnight, and that in turn put many of them in jeopardy of default. There is a side issue here about how forthcoming companies should be in reporting the drop in value of these assets. It is called “mark to market.” Here’s a little write up about it.

2. Lenders, taking a peek in the mirror, started losing trust in their borrowers. Many of the same banks that were suffering problems were less likely to loan out money – not just because they were in trouble themselves, but also because they worried about the credit worthiness of the banks, businesses, and other institutions who were looking for loans. Vikas Bajaj wrote about this in today’s New York Times – about how fear seems to be overtaking logic and normal market forces right now.
3. We’re being reminded of how much our economic system, and day-to-day business relies on easy credit. None of this is new, but this crisis has brought out into the open the traditional practice of businesses (large and small), banks, and other financial organizations to borrow money to cover short term demands for cash, and then repaying that loan shortly. They do it to buy inventory, meet a payroll day, take advantage of low prices, or to just make other investments with someone else’s money.

What is the U.S. government doing? Lots of things, many of which I don’t really understand or can keep track of. There are a couple of major activities that I can try to comment on:

1. “The bailout.” The final bill passed by Congress was larded with all sorts of things to buy the necessary votes, but the essential piece was giving the Treasury Department authority to buy some of those hard-to-value mortgage packages. This should have two beneficial effects. First, banks and institutions that sell these to Treasury get cash, which helps their own balance sheet. Second, this starts establishing a market price or value on these packages. The lack of a commonly agreed upon price or value has made it impossible to establish a market and to get these securities moving again.

2. Flinging open the discount window. Traditionally the Federal Reserve Bank, acting as the “banks’ bank” has had a lending facility for banks called the discount window. Banks experiencing temporary hard times could borrow money from the Fed at fairly reasonable rates, for short periods of time. In normal circumstances this is not used much, because the loan from the Fed also raises eyebrows from the Fed’s own bank regulators. I describe it like going to Dad to ask for an advance on your allowance – you can get the money, but you open yourself up to disapproving questions. This year the Fed has taken a number of steps to encourage banks to use this borrowing option, and has allowed financial institutions other than commercial banks to make use of it. This provides more credit and liquidity in a market where there is a shortage of both.
3. Reducing short term interest rates. The Fed announced today that it was lowering the Federal Funds target interest rate by one-half a percentage point – from 2.0 to 1.5. They announced this in concert with a number of other large countries and their central banks. This is a classic exercise of monetary policy, with the Federal Open Market Committee releasing funds into the market in order to drive short term interest rates lower. This doesn’t have a direct impact on mortgage interest rates, but is designed to help stimulate the economy, encourage more borrowing, and more consumption.

So will all these steps work? We hope so, but it is hard to tell. We’re in uncharted waters. When people ask I tell them that I’m comforted by having a Federal Reserve Chairman, Ben Bernanke, whose academic specialty as an economist was the study of the Great Depression. He’s done some of the most important work on understanding how we got into the Depression, the actions the government took (for better or for worse), and how various countries emerged from the Depression years later. Still it is a much more complicated world we live in today. I’m just relieved to have a super smart, thoughtful person in that seat, rather than a “helluva job, Brownie.”

Stock market results are discouraging, but they are not the best barometer of how things are going. They are influenced by a sort of herd mentality and investor concerns. What we want to hear is whether banks are starting to lend to one another, that companies can find buyers for short term commercial paper in order to finance their day to day operations, and that financial organizations are looking beyond their mirrors and considering how to make money by lending to others.