Credit squeeze (formerly know as a panic)
There used to be a particular financial event called a panic. There were two famous ones around the turn of the last century: the panic of 1893 and the panic of 1907.
A panic worked like this: Everything would be going along fine until something produced a lack of confidence, at which point people would take their paper money to the bank to exchange for gold. The banks, after paying out large amounts of gold, would be unable to make ordinary loans. With credit restricted, business began to grind to a halt--manufacturers couldn't borrow to buy raw materials, retailers couldn't borrow to take delivery of goods for sale, farmers couldn't borrow to buy seed, etc.
If someone who had both lots of gold and faith in the economy stepped in, lending gold to the banks so that they could resume normal lending, then the panic could be ended quickly and with little harm to the economy. If there was nobody able and willing to do that, the result was usually a depression. Multiple businesses would fail, unable to carry on without access to credit. Their banks would have to write off the loans, people would be thrown out of work, etc.
The main purpose of the Federal Reserve was to prevent this scenario. The Fed was intended to be the "someone with gold and faith in the economy," able and willing to lend unlimited amounts to sound banks, so that they could carry on with normal lending. And, although the Fed has created its own set of problems, it has succeeded at that goal: there hasn't been a classic financial panic since the Fed was created in 1913.
I mention this today, because we're just about as close to a financial panic as we've gotten since then. It isn't a panic, because "ordinary" lending hasn't been affected. There's been quite an impact on "weird" lending, though. The subprime mortgage market has collapsed, and at the same time the market for leveraged buyouts has collapsed.
Personally, I'm not sorry to see either of those go. Leveraged buyouts have generally turned out to be a way for very rich people to become incredibly wealthy, largely at the expense of ordinary workers, their communities, and small investors. If you can't qualify for an ordinary mortgage, you probably can't really afford a house--and getting fooled into thinking you could afford one by teaser rates on an option-ARM is a lot more likely to ruin your finances than turn you into a homeowner.
I don't think a classic financial panic is at all likely. Much more likely is what we've had: the Fed goes beyond being "able and willing" to lend to sound banks and lends excess money. (And, in fact, today the Fed needed to provide $24 billion of liquidity to keep short term lending rates stable. The European Central Bank provided $130 billion in overnight lending.)
These sorts of events can cause the whole economy to lurch unexpectedly in one direction or another (or first in one direction and then in the other). Interest rates may spike or fall (or go first one way and then the other.) The stock market may do the same. Very rich and very smart people try hard to predict the lurches and can make a lot of money if they guess right. My own inclination, though, is simply to try not to get squashed whichever way things go. The two keys for that are:
- Avoid debt, especially floating-rate debt. At times like these, rates can easily spike up at just the same time that some otherwise minor problem in either the job market or the banking system can interfere with your ability to make timely payments. That can take what would otherwise be a temporary economic glitch and turn it into a bankruptcy or foreclosure.
- Stay liquid--have an emergency cash reserve. Some people prefer to have all their money invested in the stock market for maximum long-term returns, and rely on credit cards to cover them in case of an emergency. That works fine when the system is going along smoothly, but can fail badly during a credit squeeze. Your bank could just cancel your credit card right at the same time the value of your investments was plummeting. The cost of some idle cash is very small compared to your possible exposure otherwise.
I don't want to sensationalize things--I think the risks are small. But there is a real risk that the current situation could get messy, and these are modest steps that I think are worth taking in the face of what will probably turn out to be a modest problem.