Can We Please Borrow The Garden Hose?

October 1, 2008 at 3:33 pm (Uncategorized)

“Suppose my neighbor’s home catches fire, and I have a length of garden hose four or five hundred feet away. If he can take my garden hose and connect it up with his hydrant, I may help him to put out his fire…I don’t say to him before that operation, “Neighbor, my garden hose cost me $15; you have to pay me $15 for it.”… I don’t want $15–I want my garden hose back after the fire is over. ” –FDR, explaining Lend-Lease in WWII to the American Public.

What I’ve had on my mind the last few days are probably the same things you’ve had on your mind: the crashing and failing US Economy. Whether you understand what’s going on or not, (and it’s taken me a while; Walter Johnson’s Econ 51 scarcely prepped me for this), I hope there’s some sort of realization that we’ve gotten ourselves into a giant mess.

It is a mess that we have to fix. Like a good liberal, I’ll state the obvious: we have to fix it by (holding our noses) and throwing money at it.

The causes for how we got ourselves this far stuck in it are fairly complex, but what we face currently happened after Lehman Brothers collapse last week. At this point, I’ll turn it over to an internet friend who knows what he’s talking about, is smarter than me, and with whom I disagree fervently and frequently over politics (but not this time, and not on this). Grifman, take it away:

“First, a little background on a key component of the financial system, money market mutual funds. Money market mutual funds are like saving accounts, except they are not FDIC insured. They invest in short term commercial paper which allows them to generally pay a bit more than bank savings accounts, which make them very popular. They are also considered very safe. When you buy a money market mutual fund, you are actually purchasing shares, which are valued at $1.00 apiece. You invest a dollar, you get a dollar plus interest back. This market is huge and supports most of the short term commercial paper market of $1.7 trillion dollars. Corporations use this for short term funding purposes and it serves as oil to the financial system. It keeps things going on a short term day to day, week to week basis.

However, late Tuesday, two money market mutual funds “broke the buck” and that’s what started the collapse of the system. Reserve Primary Fund suddenly announced that because they were holding short term paper of Lehman Brothers, which had declared bankruptcy and that $1.00 invested in them was only worth $0.97. BNY, the other dropped to $0.99. On Wednesday we started to see massive withdrawals of funds by investors from these accounts. Normally weekly redemptions total about $7B, but last week by end of day Wednesday, over $173B had been withdrawn. One fund even shut down due the volume of redemptions requested. So much money was pouring into US Treasury investments that the yield on Treasuries had dropped to zero – people didn’t care about a return, they just wanted safety.

Another problem is that people wanted their money immediately, yet these funds invest in commercial paper up to 90 days in term. If enough people demanded their money, funds would be forced to put their paper on the market, depressing prices further, causing further losses. It was the beginning of a vicious cycle.

Meanwhile the attempt of the Fed to pump billions into the system was failing. Banks normally hold about $2B in US depository reserves, money that is held for immediate use. However, because the banks now expected huge withdrawals by money market funds, they now held $190B, money that otherwise could be invested to support the economy. IBM, which has nothing to do with subprime mortgages and normally has been paying 3% or so suddenly found itself paying 8% to issue commercial paper.

Even if that went over your head, what you need to understand is this:

1. Banks are not lending money. They’re hoarding it, in expectation of “bank runs”.
2. Banks not lending money is *bad*. Lending is what moves our economy along; lending is like the oil pump to the engine of our economy–if there’s no oil pump, the engine seizes and fails.
3. Spare me the “we’re drunk on credit” speech; the credit and short-term loans we’re talking about *now* are *not* the subprime lending that kicked off this mess. Credit is a very good thing, and later I’ll show you why.

What you need to know now is this: many, many, many corporate entities do not “sit” on cash reserves. That’s a terrible way to do business! “We made $100,000 last month in profits after paying our employees and managers and meeting our obligations to cover our operating costs. What should we do with this money? I know, let’s bury it in mason jars in our backyard!” Companies that grow invest the money they carry to the bottom line. They reinvest money in themselves, they invest money in liquid investments that allow them access…they *do* stuff with their profits and incoming cash to grow themselves. With that in mind, understand that a great number of companies–in fact, the majority of companies that employ 500-5,000 employees–use a revolving line of credit to meet their payroll obligations. They get these little 7- and 15-day loans that are easily paid back in that time frame to make sure that paychecks go out when they need to, and to make sure that the company can continue to fluidly invest money instead of stockpiling it uselessly while waiting to cut payday checks.

Now understand that these little revolving credit lines are in danger of drying up and disappearing, because banks aren’t lending. That puts most of our paychecks in danger of bouncing, maybe not this week, but certainly very soon if things don’t change. It also means that companies that employ a ton of folks–think Anheuser-Busch, IBM, Microsoft, GM, Ford, etc–are hoarding their own money to make payrolls, instead of kicking that money back out into the economy. See the vicious circle there?

Realize too that “credit” is all-pervasive. When the local supermarket gets a delivery of food every day, they don’t go back to a safe and pay the delivery guy in cash. They sign a manifest or invoice with the clear understanding that the retailer will pay the supplier for the goods received in some time period–usually 30 days, but sometimes 15. That’s credit. When your cellphone bill, or your cable bill, or your electric bill arrives, the folks you have service with expect you to pay within a window of time. That’s credit, too. Credit is *everywhere* in our economy. Imagine if the supermarket had to pay cash-up-front for inventory? You really want to see “No bread today, try again tomorrow” signs in American supermarkets?

And credit is good. No really, it is. Quit thinking like a Puritan minister for a second.

I’ve seen a few folks wonder why we can’t have a credit-less, cash-up-front economy. Accountants everywhere are twitching at this, and I’ll tell you why it’s a bad idea: corruption.

People love money. We do, we can’t help it. Introduce a creditless system, and you start to undercut the paper-trail of accountability that makes businesses run efficiently. When the supermarket signs that invoice, they’ve checked off every item on it to make sure it arrived. They give no money to the driver, who carries no money on him. A few weeks later, an accountant cuts a check for the inventory they received, and only a precious few people–all of whom have oversight on one another–get access to the checkbook and bank accounts where that check came from. Our current system of little credits and “floats” throughout is set up to eliminate corruption and graft and skimming. Go to “cash-up-front” and suddenly those checks and balances collapse, and instead of worrying about folks at the top skimming for themselves, you’re now worrying about every single person along the line of getting goods to market taking a little piece for themselves. That drives prices up, which causes the kind of hyper-inflation you saw in Depression-era central Europe.

I’m usually loathe to give over great sums of taxpayer money to the greedmongers at the top of our leadership, but in this case the time for debate has passed. The economy is walking a dangerous tightrope right now, and all it’ll take is for one biggie to “blink”, and it all comes crashing down. To use FDR’s analogy here, all our houses are afire, and the time for debating what the best method of dousing the flames has come and gone. Time to just put it out, and then go back afterwards and figure out how to keep it from happening again.

1 Comment

  1. JT said,

    nicely written in terms one can understand…

Comments are closed.

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